JUNO INVESTING ©

Diversification: The Doubter’s Friend

JUNO INVESTING ©
Diversification: The Doubter’s Friend

 

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SUMMER 2016

By Martin Hawes

When the economic future is unknown and you fear the uncertainty of market cycles, then diversifying your investments is essential, as Martin Hawes explains.

The world has watched shares, property, and bond prices climb in unison and bank deposit rates sink to close to nothing. Investors in nearly every type of investment have enjoyed stunning returns over the last six years or so. However, that has left markets highly priced with little value. 

Abnormality and uncertainty are the order of the day

Unusually, perhaps uniquely, every asset class is valued highly, with very low cash yields. Pretty much everywhere investors look at the moment – shares, property, bonds, and cash – they see no bargains and relatively low income returns. According to the textbooks, this isn’t meant to happen.

In theory, some investment markets should be negatively correlated to others. That means while one asset class (say, shares) is booming, and therefore pricey, another (say, bonds) is supposed to be bust and offering bargains galore. 

The world also faces much uncertainty, with geopolitical risks – for example, in the South China Sea and Brexit) – and considerable worry about economic growth, deflation, quantitative easing, and negative interest rates. Much of this is new territory and no one knows how it will play out.

So, what should an investor do? How should we respond to such abnormal times? 

My response to this uncertainty is to go to the doubter’s friend: diversification. 

Owning a bit of everything

Diversification is usually thought of as not having all of your eggs in one basket – in other words, spreading your investment capital around. So even if one asset class (for example, shares) does badly, another (for example, bonds) will do well. The overall effect is that volatility within the total portfolio is reduced and returns are smoother.

All of this is true, but there is another way to look at it:

If we acknowledge that we are unsure of what is likely to happen (and I defy anyone to be certain at the moment), we can ease the effects of the worst of the potential adverse events by owning some amount of every asset class. In any economic event or climate, an asset class will perform well while one or more perform badly.

Diversification covers the adverse effects of pretty much any economic event. For example:

•    If we have a recession, the bond part of the portfolio is likely to perform.

•    If we have inflation, property will do well.

•    If we have an economic boom, shares excel.

•    If we have a New Zealand-specific event (for example, a bad biosecurity breach), international investments will do well.

Nearly everything that might happen to hit your portfolio can be matched by an asset that will get you through the event. 

Given that you can never be certain what the future holds, most investors will have at least some of each asset class: for example, it would be a very big call indeed to exclude bonds from a portfolio. To own no bonds is to effectively say there is a zero chance of a recession (or deflation for that matter, as bonds also do well in times of deflation).

That’s the value of diversification among asset classes. Most investors will have some shares, some property, some bonds, and some cash – if for no other reason than they don’t have a perfectly functioning crystal ball. If you have any thought of a particular event happening, you need to cover it with the ownership of some asset class or other.

Diversifying within an asset class

Diversification within an asset class is also about managing doubt. If we had perfect judgment and foresight, we would buy just one share or just one property trust or just one bond. That one security in each asset class would be the best performer, the one that would give us the best returns.

But no one has such perfect knowledge of the future. So therefore it’s right for nearly all of us to buy a spread of securities within each asset class: a dozen New Zealand shares, a dozen New Zealand bonds, and two or three property trusts. Some people even diversify their cash deposits, by using two or three different banks.

Tilting a portfolio

Shares, property trusts, and bonds can also be diversified across different industries. For example, that might mean that you hold shares in healthcare, energy, and retail industries to give you a good spread and exposure to a range of issues.

Of course, none of this means that you can’t weight a portfolio towards particular asset classes, industries, or companies. If you are diversified across all asset classes, all industries and all companies, you will get an average return. Average is OK – but some of us want or need to do better than average.

We do that by ‘tilting’ the portfolio: overweighting or underweighting certain investments. We take a position on what we think the future might be, and buy or sell accordingly.

For example, I think that the ageing of the baby boomers will lead to a great demand for pharmaceuticals, biotech, and the increasing number of medical breakthroughs. My portfolio is weighted towards the healthcare industry. I’m not so certain that I hold everything in that sector, but it does make up a relatively large proportion of my portfolio.

How much is enough?

The extent of diversification largely depends on your goals and appetite for risk. Someone who really wanted (or needed) very high returns would focus on the best asset class (or the best security within an asset class) and allocate their funds to that one area. That strategy increases risk, but if they got it right, returns could be much better.

Such people would need to have very strong convictions and be confident that they are right. They’re likely to have big goals that they want to meet and be prepared for an all-or-nothing result. 

Diversification is good when you have doubt. And the shocks we’ve seen in the markets mean you should always have at least a little doubt. Diversification is the doubter’s friend: the more you doubt, the more you should diversify.

Martin Hawes is an Authorised Financial Adviser. His disclosure statement is available on request and free of charge, or can be found at www.martinhawes.com. This article is of a general nature and is not personalised financial advice. Martin Hawes is also the chair of the Summer KiwiSaver investment committee.

DEFINITIONS

DEFLATION: An overall decrease in the price of goods and services, which can mean a fall in the value of an economy. The opposite of inflation, deflation is generally seen in periods of economic uncertainty or crisis.

QUANTITATIVE EASING: A monetary policy used by central banks to stimulate growth and increase the money supply in an economy. Usually this is done through purchasing government bonds.