Diversification is an important topic, but one that isn’t well understood. And I don’t just mean by the general public. Investors aren’t great at understanding it either, apparently. Less than half of investors surveyed by the ASX (46%) claim that their portfolios are diversified. And even that group holds just 2.7 financial products on average. A further 40%, who held 1.6 products on average, said they knew their portfolios were not diversified enough. But most worrying of all, 15% of investors admitted they didn’t know if their investments were diversified or not.
So how do you know if your investments are diversified? Or if they are diversified enough?
What is diversification?
One of the first posts on Enrichmentality looked at diversification of income streams. Essentially, it’s the principle of not putting all of your eggs in one basket. Spreading the risk around. That way, if one egg (or investment, or income stream) goes bad, you still have the others.
But there are actually several different levels of diversification that investors should consider.
It may be the case that your investment portfolio is very diversified at one level, but not diversified enough at one or more other levels.
The best outline of diversification I came across while completing my Diploma of Financial Planning. Let me share a summary of it here, with some of my own notes.
Diversification across asset classes
To understand the first two kinds of diversification, it’s important to know what an asset class is. An asset class is defined as
‘a group of securities that exhibits similar characteristics, behaves similarly in the marketplace and is subject to the same laws and regulations’.
But it’s probably easier to understand through examples. Real estate is one example of an asset class, as are shares. Fixed income, or bonds, are another type, and cash equivalents or money market instruments.
So, if you own a house, some shares, and have a savings account, you are diversified across three asset classes.
Why do you need this type of diversification?
Generally speaking, investment goes in cycles, just like the hands go around a clock in a cycle, or a wheel turns in a cycle. When one part of the ‘wheel’ is up, another part will be down.
It’s very unlikely that ALL asset classes will be up or down at once because of the relationships between them. Here’s a sample investment ‘clock’.
Once again in this post, I’m responding to an Australian reader’s question with an Australian example. But a similar version of this clock appears in most developed economies.
If you look at 11 o’clock on the ‘boom’ section, you’ll see that easier money (loose lending conditions, more loans being approved, cheap rates of borrowing etc.) means that more people can afford to buy houses, which means more competition at auctions etc. resulting in rising real estate costs (12:00).
To slow the economy down and prevent real estate bubbles, the reserve bank may then increase the interest rate to make it a little more expensive for people to take out loans (1:00).
When interest rates are high, shares will usually become cheaper (2:00), because a) people find it harder to borrow money to invest because the interest rates are high and b) people who already have cash on hand can invest it in low-risk bank accounts for a higher than usual interest rate instead of in the share market where the risks are higher.
And so on it goes, around the clock, over and over again. Of course, shocks and hiccups and global financial crises and so on do occur, but these are shocks because they are not the normal course of events.
If you hold only one asset class, when it is at the bottom of the investment cycle, you may not have enough income to support your needs, and if you need to sell, you may not be able to get a good price. If you hold several asset classes, the underperforming ones will hopefully be balanced out by those that are higher up on the cycle.
Diversification within asset classes
The next level looks at diversification within each of these asset classes.
Since property is familiar to most people, let’s take a look at that asset class first.
Let’s say you have enough money to invest in 50 properties.
You could build an apartment building with 50 identical flats. Or, you could invest in a mix of properties. Some houses, some apartments. Some rural, some urban. In various states, or even countries.
Why is this type of diversification important?
While building your own version of ‘Trump Tower’ might be appealing to those who want to see their name on a building, if that’s your only property investment, it’s a case of putting all your real estate eggs into one basket.
- What happens if your target market (e.g. students, or retirees) is affected to some big change to government policy (e.g. restrictions on study visas, or pension cuts)?
- What happens if something happens locally (e.g. the mill that 80% of your tenants works at closes? Or a big jail or rubbish dump opens up nearby?)
- What if something happens specifically to your property (like an accident or a natural disaster?)
If you have diversified, even if these things do happen to one or even ten of your properties, you’ll still have 40 or 49 unaffected, bringing in an income to support the underperforming one(s).
The same is true when it comes to shares.
The ASX is made up of companies across a variety of different sectors – broadly 10 in total, but you can drill down within these sectors to industry groups and sub-groups. You’ll probably hear about the ASX200 or ASX300 etc. which are the top 200 or 300 etc. shares (by market capitalisation, or $ value) on the market. Many investors use these indexes as a guide to ‘benchmark’ their portfolios.
Last time I checked, Financials (banks, investment firms etc.) made up around 45% of the ASX200, followed by Materials (mining and so on) at 14%. The other eight sectors all represent percentages in the single digits.
So, for instance, an investor who is interested in creating a portfolio that roughly approximates the overall market might want their exposure to Materials to be around 14%. As shares go up and down all the time, they might consider a range of say, between 4% and 24% to be acceptable. (Sticking too strictly to an exact percentage would mean buying and selling all the time as the price fluctuates, which is labor-intensive and costly as you have to pay brokerage each time).
If you have a portfolio that is diversified across a number of sectors, and even within sectors (e.g. instead of holding just 1 financial company, you might own shares in 4 or 5), you are able to spread your risk around.
On the one hand, if you had $10,000 to invest and put it all into one company, you could make money, break even, or lose it all. But if you divided that $10,000 across ten shares, on the other hand, the chance that you would lose it all is much lower. It’s very unlikely that all ten companies you select are going to go bust.
Of course, the more diversified your portfolio, the less risky it becomes – up to a point. After a certain amount – say 10 or 12 companies, if they are appropriately chosen to reflect the overall composition of the sharemarket – you experience diminishing returns. That is, the amount the risk is lowered becomes less and less. Going from 1 share to 2 halves your risk. But going from 11 to 12, or from 12 to 13 doesn’t have near the same impact. Furthermore, the more companies you own shares in, the more things you have to keep on top of – more certificates in the mail, more voting forms for shareholder meetings, more individual divdidends to declare on your tax return… the list goes on. It’s much harder to keep on top of the financials of 100 companies than it is on 10 or so.
One way to achieve a high level of diversification without having to keep track of a bunch of different companies is to invest in a fund.
An index fund is one which attempts to replicate one of the major indices out there, like the ASX200. You pool your money with a whole bunch of other investors, and collectively buy pieces of each of those companies. Instead of owning $1000 of one company, for instance, you could own a few cents’ worth of hundreds.
A managed fund is one with a professional manager who chooses the shares for you and other members. It’s like an index fund in that instead of owning, for example, $1000 of one company, you could own a few cents’ of hundreds, but instead of those companies simply being the 200 largest companies on the exchange, for argument’s sake, they are hand-picked by the manager.
Diversification across managers
This is perhaps the least frequently heard of kind of diversification. Essentially, diversification across managers refers to having more than one person (or company) looking after your assets.
Even if you own tiny pieces of literally hundreds of companies through a managed fund, since the person or team selecting those shares is the same every time, they will be subject to the same biases and gaps in knowledge over and over. Likewise, even if you have a healthy portfolio of shares and property that you have put together yourself, those assets in both asset classes were put together by you, with your level of understanding and assumptions about the future. For example, you might have a hunch that mining is going to do really well, and be partial – consciously or unconsciously – to shares in companies that support the mining industry, and real estate in mining towns. If mining goes bust, so will you.
Why is this type of diversification important?
Even if you learn a lot about investing, you’ll never know it all. Nobody does. Everyone makes mistakes.
But leaving it all up to the professionals – especially one professional – is not always a great idea either. Many people over the years have been horribly ripped off by financial advisors they thought were investing on their behalf, but who turned out to be embezzling funds.
It is hugely important to make sure that you can trust whoever you invest with. Don’t hand over any money, or any authority, unless you really feel comfortable about it, and make sure that whoever you pick is appropriately accredited and registered. In Australia, you can access the Financial Advisors Register on ASIC’s website. This is especially important if you are considering more than one investment with the same firm. If you use a financial advisor to help you with a mortgage, an investment property, a domestic and international share portfolio, some managed funds, and your bank accounts, you really need to be able to trust that individual – and know that they have an appropriately qualified, trustworthy team. It is very rare for any one person to be expert across that many asset classes at once.
It gets easier
One of the more depressing facts about investing is that those who need diversification the most – i.e. those without millions of dollars in the bank – have the hardest time obtaining it. If you can’t afford to pay one financial advisor’s fees, you certainly can’t afford to pay for two. Many funds have minimum investment hurdles of $25,000 or more, which is just insane for someone starting out. Property investing is even worse.
When you don’t have a lot of cash, your only real option is to DIY with the entry level assets you can afford. The more money you have, the more you can afford advice and services, and the more you can diversify.
So does that mean I should just give up on investing?
Back in our 20s, when I was a graduate student (and my husband and I were still paying off our mortgage), we decided to invest in some shares as a learning exercise. There are all sorts of ‘paper trading’ and online games you can play (pretend investing for educational purposes). But as we’ll get to in a future post, it’s true that nothing emotionally prepares you like using real money that you have worked hard for.
We started off with three companies into which we invested $1,000 each. We made sure they were from different sectors, so that we had some basic diversification, but we didn’t worry too much about benchmarking etc. until later in the game, when we had paid off our home loan and were getting more serious about investing.
These small investments gave us a bit of a taste of the sharemarket for a relatively low risk (because it was money we could afford to lose). As I’ll outline in an upcoming post, I think it helped prepare us for the emotional rollercoaster of putting together a somewhat more balanced and diversified portfolio later.
If you have some money you can afford to spare, and want to give investing a go, don’t let the fact that you can’t immediately build a fully diversified portfolio stand in your way. It’s something important you need to consider, but it is something you can work towards over time.
The key lesson is to be aware of these three types of diversification and work towards achieving them.
You may already be more diversified than you think!
If you have a retirement account like superannuation in Australia, don’t forget to include that in your calculations! Unless you have a self-managed super fund, right off the bat, you have diversification of managers if you handle your own investments or rely on a financial advisor, and have a separate super fund managed by someone else. You can also check to see whether your super fund is diversified across and within asset classes – and whether, when you put your assets inside and outside of super together, you are over or under exposed to any particular asset class.