Diversification needs homework in shifting eggs to new baskets

Compounding this, many investors are putting their portfolios on cruise control and are risking a collision if investment conditions change.

Research just completed by InvestSMART, covering almost 25,000 Australian investment portfolios and about $15 billion in personal assets, shows many investors are overweight in different asset classes, and underweight in others, and are missing out on opportunities to minimise risk and achieve higher investment returns over time.

The majority are heavily exposed to domestic equities and residential property (See Rosemary Steinfort’s feature elsewhere in Wealth today), but they are underweight in international equities and fixed interest.

This trend is most evident at the lower end of the investment spectrum, covering investment holdings of up to $50,000.

Investors in this band have on average around 55 per cent of their capital tied to direct shareholdings in Australian companies. A further 37 per cent is held in managed funds, and the remainder (about 8 per cent) is mostly tied to cash in the form of term deposits.

In the $100,000 to $250,000 assets band, many investors still have more than 80 per cent of their capital linked to shares and managed funds, but also have small exposures to property and alternative assets.

Those with larger portfolios, ranging from $250,000 up to $10 million, have close to 40 per cent of their assets tied to domestic stocks and about 35 per cent in direct property.

Alternative assets

Not all that long ago, a global boom in commodities prices fed by strong demand meant Australia’s resources sector was the place to be for capital growth. Similarly, investors seeking high yields flocked to the banking sector, in the process pushing up bank stocks to record levels.

Yet volatile global economic and financial conditions have seen both of those sectors, and many of the stocks within them, lose substantial ground.

By contrast, due to other circumstances and events, demand for technology and healthcare stocks has brought about some spectacular returns.

In Australia, returns also have been particularly good from listed property trusts, linked to the strong real returns from the residential and commercial property sectors.

But even investors who make the correct choice when they buy in, investing into the growth sectors of the day, need to be attuned to changing market conditions and their portfolio structure and needs.

Peter Hogan, head of technical at the SMSF Association, says investors need to start looking at alternative assets to have further diversification within their portfolios.

“The fact that interest rates have come down so significantly has tested the whole idea of having large amounts of cash,” he says. “For a lot of people the GFC is still very fresh in their minds. And that’s fuelling them to be more conservative.

“But retirement is not a finite time, and from an investment viewpoint it is a long time horizon. So being in retirement is not a reason to become too conservative.”

Reality check

Fundamentally, every individual’s investment goal is different, but a lot of one’s decision-making process is governed by time horizon and risk profile.

A shorter time horizon will have a lower exposure to Australian equities and a higher allocation to fixed interest, while longer time horizons of 10 years or more will warrant higher exposures to both Australian and international shares.

In the same way as one should get a physical health check from time to time, the best way to get a financial reality check is to test your investment holdings and allocations using a portfolio management tool.

Listing all your assets (and liabilities) including shares, super, managed funds, property and cash will present a clear picture of your overall financial health and net worth.

Doing so will quickly reveal whether you are too heavily weighted to certain shares or sectors, or to different asset classes, and underweight in others, based on the type of investor you are and your investments’ time horizon.

A financial check will give you a “diversification score”, which indicates how closely the allocation of assets within your portfolio is aligned to the target allocation for your chosen risk appetite.

Getting the correct asset allocation is very important for ensuring that you get the best return for the risks you are taking with your investments.

Balancing act

For investors with a lower-than-recommended allocation, the most prudent course of action is to rebalance one’s asset allocation to improve diversification, reduce risk and improve returns.

A good way of doing this is to simulate changes to your current investments and/or add new investments to see how they could affect your overall portfolio’s diversification.

But, before leaping in to any investments, it’s vital to undertake comprehensive research.

This is an area where many investors fall short, and often either overpay or fail to take into account the underlying dynamics of either the broader market, a particular sector and, when buying shares, those factors impacting a specific company.

Various tax benefits in Australia provide reasons to hold direct equities and other investments. However, diversification across asset classes is important in minimising risk and potentially improving returns.

The key to successful portfolio management is having, and sticking to, defined investment objectives.

Emotion should never come into play, but when circumstances dictate, active investors should be prepared to respond.

It’s all about being in control, using the vast array of information available to build and maintain a well-balanced portfolio of assets and to maximise investment returns over the longer term.