Diversification of investments sounds boring and pointless when markets are on the rise. Everyone seems to know best and the often heard belief is that this investment cannot fail. However, think about people in Greece whose retirement was totally reliant on a government pension, or those in Australia who built businesses based entirely around the mining boom.
Eventually, when markets rise faster than are economically sustainable and when people use debt to leverage themselves further into those markets to make larger profits, then when the inevitable correction arrives, many market participants end up getting hurt. One only has to pause for a minute to consider the risks associated with investing into an absolutely overheated Auckland housing market. The government, economists, bankers and market commentators are all warning of the dangers in the Auckland housing bubble but still people borrow like there is no tomorrow to speculate on the Auckland miracle property ride. Unfortunately, sometime soon, that miracle will also turn to tears and it is often those who can least afford it that get hurt the most.
The second quarter of 2015 proved the worth of diversification. The period was tumultuous for the markets but a weakening NZ dollar saved the day. Milestone firmly believes in the principle of diversification. However, our view of diversification goes well beyond just diversification of individual investments. We commence with geographic diversification where we recommend clients have a good percentage of their money invested into international shares and high quality fixed interest. We have all seen how quickly the NZ economy can turn from a ‘rock star’ to a ‘no-star’ in the space of 6 months - primarily due to a fall in dairy pay outs and an overheated dollar. If one has their house in NZ, their pension is paid for from here, their employment comes from a domestic NZ company and perhaps they also have a rental property, then all this could take a severe hit if a calamity, for example foot and mouth disease, struck the country. The percentage we recommend to invest overseas is dictated by your time horizon, risk profile and whether you need regular income or long-term capital gain from your portfolio.
Next comes diversification into asset classes such as shares, fixed interest, property and cash. The principle here is that if one asset class is doing poorly, then another will compensate through good performance. This diversification is designed to help smooth portfolio returns. For lower risk investors, the theory is to have more of the portfolio exposed to income assets such as cash and fixed interest and for those with a higher risk profile, the theory is to have a higher exposure to growth assets such as shares and property.
The third level of diversification is into different sectors within the asset classes. In the case of shares, we would ensure that not all the investment is into a range of companies all in the one industry or market sector such as mining, agriculture or property. This helps reduce the risk of being exposed to a down turn in a particular sector of the economy.
Finally, we diversify between individual investments to reduce stock specific risk. This means a company or a bond may strike difficulty for a period but that investment is only one small part of the overall portfolio and hence its underperformance does not damage your lifestyle. This sort of diversification will normally see individual stocks or bonds being under 5% of the entire portfolio.
It is times like these that the age old principle of diversification or “don’t have all your eggs in the one basket” rewards the prudent investor. No investment market can keep producing stellar returns year after year without eventually becoming over-priced and having to fall in value to reach economic viability.
Talk to a Milestone adviser about where we see the market ‘bubbles’ and heightened risk, and seek advice about how to better diversify your overall asset base (not just your investment portfolio) so you can minimise the inevitable market ups and downs.