The role of diversification
Diversification plays a key role in long term investing. To understand why, it can help to think about what goes on at the racetrack, where the bookies always seem to win while the punters are invariably left empty-handed.
The secret to bookmakers’ success is that they spread their risk by continually changing the odds to encourage punters to back as many different horses in a single race as possible. This spread of money means the wins should outweigh losses.
Punters, on the other hand, concentrate risk by betting on just one horse in each race. Unless the horse wins, the punter loses his money.
When it comes to investing, the strategy of spreading your money so you have a little in a broad number of investments, not a lot in one, can strengthen long term returns and minimise losses in much the same way that bookies hedge their bets.
Sticking to what we know
However, a wealth of research shows diversification is a weak spot for many investors. The ASX found we tend to stick to cash, property and Australian shares. In addition to concentrating risk, this can mean missing out on decent returns earned by other asset classes.
As a guide, a recent ASX/Russell report found residential property topped the league table of returns for mainstream investments over the last 10 years, averaging gains of 8.1% annually. What’s surprising is that over the same period, global bonds (hedged) and Australian bonds were the next best performing investments with average annual returns of 7.4% and 6.1% respectively.
Aussie shares didn’t even make the top four, earning an average of 4.3% annually over the past decade. To be fair, this period includes the global downturn when sharemarkets tanked. And yes, more recently, we’ve seen sharemarkets fall – though not by anything like the same extent. However, seasoned investors will know that short term dips are quite normal for shares, and history confirms that quality shares will go on to not only recoup their value but also rise in price over time. In fact, market falls can represent good buying opportunities as quality stocks are available at discounted prices. Panic selling is the thing to avoid as this just cements losses that may otherwise be “on paper” only.
Back to the ASX/Russell study, cash assets delivered woeful returns of just 2.8% annually over the 10-year period.
Expanding your portfolio
It’s a compelling argument to consider expanding your portfolio beyond the mainstays of cash, bricks and mortar and local shares.
This is an area where your adviser can deliver tailored recommendations. However, investments like bonds, infrastructure (which incidentally returned 13.3% globally over the last year), or international shares (10.6%) can be good additions to a portfolio.
These types of investments can be difficult to access as an individual investor, and a managed investment fund – either listed or unlisted, offers an easy way to expand your portfolio into new areas and reap the rewards of diversification. Speak to us about what could work best for your portfolio
Paul Clitheroe is a founding director of financial planning firm ipac (now known as AMP Advice), Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.