Canny investors spread their wealth among a variety of assets to maximise long-term gains and protection from economic vagaries, writes Dave Wilson.
In the past two years, investors lost a lot of money through finance company failures. Much loss was avoidable.
These investors made the mistake of failing to diversify their investments. Diversification within an asset class, such as finance companies, only protects from isolated cases of fraud or bad management.
Diversification is the first rule an investor learns, but it is also the most misunderstood. Owning a portfolio of several different corporate bonds is not diversification. Should inflation re-emerge, such a portfolio may look as imprudent as a portfolio of finance company debentures looks today.
Choose assets that do not always move in the same direction. A typical portfolio will include cash, fixed interest, shares, property and commodities. Antiques and art may have a place in an investor's portfolio, but it is important to understand these assets before buying.
Long term, riskier asset classes such as shares are expected to achieve the best return. However, they can experience long periods of underperformance, yet again highlighting the importance of a varied portfolio.
Assets perform differently depending on the circumstances. For the past 20 years, the Reserve Bankhas targeted low inflation. During this period, bond investors enjoyed strong returns.
But low inflation is unlikely to be the Reserve Bank's only focus in the post-financial crisis world. So real assets such as property and commodities are important.
In the 1970s, bonds performed poorly as inflation eroded their value. Returns from most shares were also lacklustre as economic growth stalled and governments froze prices to control inflation. Commodities, however, performed strongly.
A commodity is a physical substance used in manufacturing goods or foods, such as wood (forestry), oil, industrial metals (eg copper), precious metals or food basics such as grain or sugar. Commodities can be held directly, such as forestry partnerships, or in diversified baskets. Unlike shares, no commodity has ever significantly outperformed its peers.
Gold has recently gained prominence, but its performance during the deflationary 1930s and inflationary 1970s was no better or worse than other commodities such as oil, sugar or copper.
From 1970 to 1979, commodities rose in value by 586 per cent, or 21.2 per cent a year. A 10 per cent exposure to this asset class would have improved returns by around 2 per cent a year.
This could be the difference between an 8 or 10 per cent a year return for the decade. A $100,000 investment would turn into $216,000 if it returned 8 per cent, but $260,000 if it returned 10 per cent; an improvement of $44,000 or 44 per cent of the original investment.
Portfolio managers commonly gain exposure to commodities via the futures market, where commodities are bought and sold but with a future delivery date. The contract is rewritten with a new delivery date so settlement never actually occurs. This means a portfolio manager never has to store commodities.
A portfolio should have 5 to 15 per cent of assets in commodities. Investors in KiwiSaver or managed funds should put money into commodities in case fixed interest or shares produce poor returns.
A DIY investor can access a diversified basket of commodities by buying an exchange-traded fund such as iShares GSCI commodity-indexed trust.
* Dave Wilson is the principal investment strategist at NZ Funds Management.
