"The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defence — significant emphasis on keeping things from going wrong — is an important part of every investor’s game.” – Howard Marks
When it comes to investing, one of the best things you can do to reduce risk and improve returns is to diversify your portfolio. Or as Howard Marks calls it (above), to manage your “defence”.
Diversification might be a term we hear said a lot, but in Australia many people don’t practice this.
They have a home bias towards their investments which resembles putting all investment ‘eggs in one basket’.
They continually invest in Australian shares, Australian property, and cash (you guessed it, Australian cash).
If the Australian property market had a pull-back, as many people predict may occur, it would significantly affect banks' loan to value ratios and bad debt expenses.
This change in risk would flow on to downward pressure on the prices of bank stocks, and guess what?
On the Australian stock market (i.e. the ASX200) over 25 per cent of the index is made up of just four companies – the big four Australian banks.
So, if Australian property were to go down, so would bank stocks, which would weigh down the whole ASX200 – as you can see these two assets hardly qualify for a diversified asset portfolio.
This is a useful demonstration of the potential pitfalls of investing your money in just two assets.
It also shows how a well-diversified portfolio can help reduce the risk and impact of any one particular investment going backwards, and the importance of ‘defence’.
Every investment carries risks and is subject to potential unforeseen changes. No investment, not even government bonds or bank deposits, is ever completely safe and guaranteed.
If your portfolio is narrowly invested in a limited number of assets or sectors, then an unexpected change in conditions affecting those assets or sectors could have a drastic impact on your returns.
However, if your investment ‘eggs’ are spread across a variety of sector and asset ‘baskets’, each with different characteristics and profiles (i.e. what experts coin ‘uncorrelated’ assets), then the risk of your portfolio being impacted by change will be reduced.
This is because the negative performance of some investments will tend to be neutralised by the positive of performance of others, and over the longer term, the entire portfolio will be expected to yield higher and less volatile average returns.
So what else is there apart from Australian shares, Australian property and cash?
International shares, emerging markets, international property, infrastructure and fixed interest are other asset classes which offer great diversification for investors.
Furthermore, through exchange-traded funds (ETFs) it’s now possible to deliver investors a highly diversified portfolio for a fraction of the traditional cost.
Using this approach, your money can be invested across literally thousands of companies, sectors, asset classes and positions – instantly and inexpensively delivering you a truly diversified portfolio.
Ted Richards is the director of business development at Six Park.