Mark Lister: World's disasters give lesson in diversity

Diversification is a hedge against uncertainty and risk. Diversify so that a market collapse caused by external events doesn't leave you high and dry. Photo / AP

Events speak louder than words. The past three months have taught us more about investment than any textbook ever could.

We can wax lyrical about the importance of being diversified and having a balanced portfolio to protect savings (and income) against risk and uncertainty, but there is nothing like real events to make the point.

The first quarter this year is "exhibit one" in any demonstration of the importance of diversification. During these three months, we have seen terrible natural disasters, conflict in the Middle East, rising food and fuel prices, a falling currency, volatile sharemarkets, falling house prices and falling interest rates - all of which serve as a reminder of the value of having a diversified portfolio.

In many ways, your investment portfolio is an insurance policy. It is a hedge against uncertainty and risk, and a safety net of capital that can take some knocks, generate income and will still be there when you need it. As the past quarter has shown, we live in an uncertain world. Diversification is the best way of managing uncertainty. Investment portfolios should combine cash, fixed income, property and shares. A proportion of the portfolio should be invested outside New Zealand.

As well as illustrating the importance of diversification, the past quarter highlighted other issues.

Firstly, don't panic. Stay the course. The NZ market was up 4 per cent over the quarter and 35 per cent over two years. In early March 2009, at what seemed like the height of the global financial crisis, sharemarkets quietly made a bottom and started what has turned out to be a startling recovery.

So no matter how dark and scary is the outlook, always keep some of your portfolio in shares. Sure, tilt your portfolio towards cash and bonds and away from shares when you are worried about the world, but never sell out altogether.

Hedge sharemarket volatility with fixed income - as we saw during the quarter, markets can be unpredictable and volatile. In the days after the Japan earthquake, sharemarkets fell sharply, as did our currency. But they bounced back. The best protection against this volatility is ensuring your asset allocation, especially the mix between low-risk income assets and growth assets, lines up with how much risk you are willing to take. If market ups and downs are disturbing your sleep, take a step to the conservative side and increase your weighting to fixed income.

A process of regular, perhaps annual, rebalancing is an important way of controlling risk. When markets move strongly in one direction, it can mean your original asset allocation becomes skewed in favour of one asset over another. It can pay to rebalance your portfolio to its original settings by reducing the asset that has gone up and buying the one that has gone down. It is a practical implementation of the simple but powerful investment adage to "buy low and sell high".

Rebalancing helps mitigate the concern we feel when sharemarkets rise rapidly. It worked particularly well in 2007 when rebalancing a portfolio away from shares after they rose sharply helped mitigate the losses that followed in 2008 when shares fell by 40 per cent.

With shares again up sharply in recent times, another round of rebalancing might not go amiss.

Ensure you have some foreign reserves. We have a small, relatively vulnerable economy. The Christchurch earthquake recovery is going to have a material impact on our economy. In terms of cost to GDP, it will have about three times more impact on us than Japan's disaster will have on its economy.

It is prudent to diversify our savings outside New Zealand. Include some overseas shares and deposits in your portfolio as insurance against "New Zealand risk". The Reserve Bank holds a portfolio of foreign currency reserves on its balance sheet. We should too.

It is often said that liquidity is never an issue, until it is. One suggestion for the weakness in the gold price after the quake and tsunami in Japan was possible selling by the Japanese central bank to raise cash. Liquidity is vital in crisis. It is important that if you have assets in your portfolio, such as property, that are illiquid and can take time to sell, to also have other investments that are more easily accessible. A portfolio of financial assets such as cash, tradeable bonds, listed shares and listed property securities can be an important source of liquidity.

While many of us are happy to see our mortgage rates remain at low levels, not everyone wins when interest rates fall. People with their entire portfolio in short-term deposits are vulnerable to falling rates.

Last month, the Reserve Bank cut the official cash rate by 0.5 per cent, to 2.5 per cent. This was in response to the economic impact of the Christchurch earthquake.

The governor has said he gets more letters of complaint when he cuts the OCR than when he raises it. I presume these letters are from people who live on income from their deposits.

Deposit rates have fallen from more than 8 per cent in 2007 to 4 per cent. Their income has effectively halved, and could fall further if bank deposit rates come more into line with the OCR. Such is the danger of relying entirely on cash deposits.

Not only do cash investors have to tolerate low interest rates, but they are faced with high inflation. This means that real returns (returns after adjusting for inflation) are negative.

The average six-month deposit rate from the RBNZ website is 4.7 per cent. If we take tax at 30 per cent off this we get an after-tax return of 3.3 per cent. Inflation at the end of December was 4 per cent so, after also adjusting for that, we end up with a net, real return of -0.7 per cent.

Investors should include growth assets and inflation-linked assets in their portfolios.

To see the impact of these higher living costs one has to look no further than the petrol pump. The Japanese disaster, including the nuclear emergency, and the unrest in the Middle East have served to highlight the world's energy quandary. The demand for energy is growing at the same time as the need to reduce carbon emissions. For many countries, nuclear power is the only viable option, but others may back away from it because of safety concerns. This is likely to keep oil prices high, as demand will switch back to fossil fuels while renewable alternatives are developed. Investors should hedge rising energy costs by including oil stocks in their portfolio.

Other living costs, such as food and electricity, can also be hedged by owning companies that benefit from these rising costs. Ever-increasing power, supermarket or pay TV bills become marginally less frustrating when they are offset by regular and rising dividend cheques from TrustPower, Woolworths or Sky TV.

To provide a hedge against as many costs, eventualities and risks as possible a portfolio needs to be broadly diversified. There's that word again.

Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.