Most of us think that an investment portfolio consisting of the family home, some holdings in Aussie shares and cash is diversified enough. But is it really?
The best way to determine whether your portfolio is adequately diversified is to project into a scary future: would your investment portfolio continue to perform modestly if, say, Australia went into recession? In other words, if the property and sharemarket slid simultaneously, would you still achieve single digit returns or higher? Or would your portfolio tumble into the negative?
For your portfolio to hold up within a domestic downturn you would need alternative investments to Aussie shares and property; some examples are bonds, international shares and managed funds, investments in commodities such as gold, or alternative asset classes like infrastructure, hedge funds that trade both long and short, and private equity. Diversification is all about spreading your assets across investments that aren’t correlated.
If you think that your exposure to Australian shares and property is too high, there are some strategies that you can employ to distribute funds elsewhere.
– You can sell down underperforming areas of your portfolio
– You can sell down overperforming areas of your portfolio
Indeed, these are completely opposing strategies and it’s hard to tell which one will work better than the other.
Your choice as to which strategy is most effective will depend on a couple of things – one being your tax situation. For example, if you’ve already realised a large capital gain this year, selling loss-making investments to offset that capital gain in your tax return might be more suitable. Alternatively, if your assessable income will be lower this year than usual, then you may consider taking profits on investments that have already run.
Clearly, your choice as what to do will also hinge on your views on these particular investments; if you suspect that some of your shares are looking toppy, you may consider selling despite the tax bill you’ll be up for.
The other concern is portfolio drift, which naturally occurs when your total portfolio’s value drifts towards the best performing asset classes. It may be exacerbated by your actions as well, buying more of the hot sector or market. The resources boom is a good example; the well-publicised mining boom has seen many investors buy the ‘next hot mining stock’ – leaving their portfolio perilously exposed to a downturn in mining.
Financial planners often encourage clients to rebalance their portfolios every three years or so. Often the rebalancing is done mechanically – the wrap or master trusts holding the managed funds automatically re-allocates funds between the different asset classes. While this gets the job done, intelligent investors can be more discerning. For instance, if you believe that Australia is entering an inflationary period, then you may consider holding commodities such as gold, and a slightly reduced exposure to fixed interest products that have no inflation hedge. You can use your investing expertise to establish a more appropriate asset allocation for today’s markets.
When undertaking a diversification audit on your portfolio, you should also check to see if you are diversified within asset classes. For instance, do you have a fairly even weighting of growth and value stocks – or are you over exposed to growth stocks, for instance? Managed funds tend to pick stocks according to a value or growth bias. While some are style neutral, this tends to be the exception. Check to see what style your managed funds employ and compare that to your individual stock holdings. You may find that you are too heavily weighted towards growth stocks relative to value stocks or vice versa (remember, value stocks are those that tend to trade at a lower price to their valuation, whereas growth stocks trade above their valuation on the prospect of strong future growth).
When auditing your share portfolio, investigate whether you have an even weighting of small and large cap stocks. In today’s market, many stock enthusiasts may find that their exposure to junior miners far surpasses their exposure to large defensive companies, for instance. Since large and small companies tend to perform well at different times in the market cycle, establishing a more even balance of market capitalisation stocks can increase your level of diversification.
Your ability to rebalance your portfolio may not be possible if you have lumpy investments, however. Some DIY super investors own a number of investment properties – and believe that they are adequately diversified because they hold not one, but two or three properties. Not only are these investors severely lacking diversification, the investments are terribly illiquid. Investors with large, lumpy assets need to hold more cash on hand in case of unforeseen events. Furthermore, these investors need to audit for the worst-case scenario. If the property market declined, would their overall super portfolios continue to perform well?
In summary, diversification isn’t about holding a number of different properties, or shares, or bonds – but holding a sensible mixture of all three. It’s about holding as many non-correlated assets as possible, without jeaopardising your returns. In fact, a well-diversified portfolio should actually achieve higher returns over the long haul than one that’s highly concentrated in a couple of asset classes. In every year of investing, there should be at least one or two asset classes and markets in your portfolio that are performing well.
This is for general information purposes only and does not constitute investment advice. Please see a financial adviser before making any investment decisions.