Money: Diversification the golden rule of investment

Of all the various investment rules, diversification has got to be up there as one of the most important.

Diversification is a basic principle of investing and, as Mark Fryer of the Weekend Herald pointed out last week, entire forests have given up their lives in publicising that principle.

Even so, many, many private clients' investment disasters can be traced back to a lack of diversification.

Why, when everyone knows how important diversification is, do so many otherwise sensible investors ignore this basic rule?

Given the extent to which diversification has become part and parcel of investment best practice, there must be some powerful forces pushing people in the other direction - towards concentrated, higher-risk portfolios.

This report looks at these factors and seeks to understand what they are and how they influence both our decision-making and the advice we get from the professionals.

PROBLEM 1: Greed


That's right. In many cases a concentrated investment portfolio results from plain, old greed, otherwise known as the pursuit of high returns.

And more often than not, investors have no one to blame but themselves.

The best local example that springs to mind is Brierley Investments.

Throughout the '70s and early '80s Brierley shares performed fabulously, reinforcing the wisdom of a strategy of bigger and bigger weightings of BIL in share portfolios.

For many New Zealand share investors, while BIL might have started off as 5 to 10 per cent of a portfolio, after price rises and the effect of the hefty annual cash and bonus issues, by 1986 to 1987 weightings of 30, 40, 50 per cent and higher became commonplace.

All well and good until ... the 1987 sharemarket crash.

The rest of the story we know, but the solution is quite simple. If you cannot or are unwilling to manage a share portfolio yourself, buy a managed or index fund.

If you must own specific shares, regularly rebalance the portfolio, keeping in mind the relative market capitalisation of the shares owned.

In the Brierley case, one should have sold those cash issues, not taken them up. Easy to say, harder to do.

PROBLEM 2: New Issues


People say that initial public offerings are the lifeblood of a stock exchange, but portfolio theory suggests that new issues should be subscribed for largely by institutions rather than individuals.

Stockbrokers in New Zealand often see portfolios which have been constructed on the basis of each stock's likely gain on listing, rather than with any regard to diversity.

Such a strategy is usually a recipe for disaster, not least because the promoters of the issues usually have a better feel for timing the market than the retail investor.

To make matters worse, individuals do not always follow the plan and take the immediate gains, but rather tend to believe the stories circulating at the time, let their "winners run" and thus retain an undiversified portfolio.

Even the best performing new issues involve something of a trade-off - do you take the profit straight away and risk incurring capital gains tax on your entire portfolio, or do you hang in there with an undiversified, and thus risky, portfolio?

It amazes me that some advisers continually promote small, specialised shares to retail investors when portfolio theory, not to mention common sense, suggest they should go directly to managed funds.

Of course this sort of clinical approach ignores the tendency of some people to "have a punt." But I don't find losing money and taking risks all that much fun.

PROBLEM 3: Fashion/Performance


Despite theories such as the efficient market hypothesis, fashion has a pervasive effect on financial markets - influencing retail and institutional investors alike.

Combined with a year or so of stellar returns, the fashion/performance combination can be very hard to resist.

The trick is to realise when the popularity of the fashion becomes disproportionate to the underlying fundamentals.

A cynic might remark here on the ability of the securities industry to forecast the fundamentals to fit the share price rather than the other way around.

The most recent example of investment fashion is, of course, the technology phenomenon.

A couple of prospective clients criticised an investment proposal in March because I had not included any specialist technology stocks.

The fact that the share funds in the recommendation had about 30 per cent of their funds in technology issues apparently did not count for much.

Before the technology fashion, we had "restructuring Europe," "emerging markets" and "Europe post-Glasnost" fashions.

Investment fashions come and go, and if you are lucky enough to forecast the next one, you can gain extraordinary returns. But most of us are doomed to follow the leader and, as the investors who piled into emerging markets in 1993 and still haven't got their money back know, it's a loser's game in the long run.

In contrast, by buying a balanced portfolio you guarantee your exposure to the next fashion, so that when someone ambles up to you at that cocktail party you can honestly say "Oh, I've owned Turkish bio-tech stocks for ages."

PROBLEM 4: Fees


Love of money is supposed to be the root of all evil, so it's no surprise that in many instances, investment portfolio construction owes more to the higher fees payable on some products than any sound commercial rationale.

One of the most obvious local examples of this problem is the syndicated property partnerships where "mum and dad" are advised to put their money into one (often provincial) building.

While the same adviser might recommend a globally diversified share portfolio they will also sell one property, in one sector, in one country, in one town.

The contradiction of such a combination is obvious, but the fact that these property instruments often produce fees two or three times the norm is a powerful attraction.

So powerful, in fact, that instead of the "normal" 5 to 10 per cent property component in their portfolios, some investors end up with a single property comprising 30 or 40 or 50 per cent of their assets.

Again, diversification goes out the window.

While the obvious solution might be to opt for a fee-based adviser who will charge the same fee no matter what initial charge is payable on a particular investment (they rebate the commission to you) this strategy does not guarantee success.

Some advisers depend as much on the ongoing "trailing fees" which many investment products pay, so will prefer those funds that pay such fees.

As share funds typically pay the highest fees, it is no surprise that shares often feature prominently in the portfolios of some clients who might be better served with bonds.

I recall seeing a recommendation for a $600,000 investment for a Tauranga couple, both in their 80s, that was all share funds.

PROBLEM 5: Adviser Bias


Advisers are only human (in most cases), so it's inevitable that some have long-term love affairs with particular asset classes or types of investments.

Some like forests, some push high-yield stocks, a few flirt with government bonds, many gravitate to risky investments.

So it pays to know how your adviser invests his or her money, so ask.

If you are 60 or 70 and your prospective adviser tells you he has lost half his money in a dot.com disaster but expects to get it all back and more via a South Korean bio-tech float, maybe he is the wrong fellow for you.

It is critical that you understand what your adviser thinks the words diversification and risk mean.

* Brent Sheather is a Whakatane sharebroker.