Six rules for knowing your limits

During the global financial crisis, I did something that, in retrospect, was remarkably stupid. It was my most expensive, and most valuable, mistake.

During the global financial crisis, I did something that, in retrospect, was remarkably stupid. It was my most expensive, and most valuable, mistake.

Prior to the GFC, I owned a concentrated portfolio focused on three stocks: Flight Centre, Infomedia and junior oil explorer Roc Oil. The problem with such a concentrated portfolio is that you need to be right - one mistake can set you back years. Sadly, I wasn't.

Roc Oil was a disaster for a host of reasons. I could have protected myself from it had I respected my capital and refrained from "investing" too much in such a speculative situation. Portfolio limits are designed to help you intelligently diversify your portfolio and avoid such grievous errors.

The problem with portfolio limits is that they're blunt tools. So here are six rules to help you tailor the right portfolio allocation limits for you.

1. Define your portfolio

Your portfolio consists of two types of capital. The first is human capital (you) the second is risk capital (your assets). Human capital incorporates your future earnings while risk capital includes all your financial assets, such as your home, investment properties, cash, bonds, managed funds, stocks and gold.

If you have limited future earnings capacity, you need to preserve your capital and avoid big risks. .

2. Define your stock universe

Even if you're a retiree your superannuation and investments might need to last for another 25 years or more.

That means not stuffing all of your savings into term deposits that don't protect against inflation.

Look for reliable businesses that pay attractive dividends, such as Woolworths and Metcash.

Remember the secret to accumulating wealth is to reinvest at high rates of return and let compound interest do its work.

3. Set appropriate portfolio limits

Having a concentrated portfolio of cheap stocks should provide higher returns over time than a more diversified portfolio. But if you can't afford to make many mistakes, then investing 5 per cent in any one stock is probably enough.

4. Check for correlated risks

Just because you've selected a variety of different stocks doesn't mean your portfolio is insulated from large, common risks.

Look for stocks that share common industries, common funding sources, common currencies, a reliance on consumer spending, Chinese capital expenditure, oil prices and so on.

If you own your home and an investment property, then consider avoiding stocks that would be directly affected by a housing downturn, such as banks - especially Commonwealth Bank and Westpac - property developers such as Sunland Group, Brickworks, Washington H. Soul Pattinson and so on.

To help avoid correlated risks, I recommend keeping investments in the banking (including income securities issued by banks), insurance and funds management sectors to 10 per cent each no more than 25 per cent in total.

5. Consider international diversification

Diversifying overseas can be an efficient way to reduce risk, assuming you remember the golden rule to only ever buy underpriced securities. You can buy stocks listed overseas or buy Australian-listed stocks with overseas businesses (such as QBE Insurance, Computershare, Cochlear and CSL). Then there are the exchange-traded funds and managed funds, or you can invest directly. It's cheap and easy to set up a foreign brokerage account.

6. Examine attitudes to cash

If you want cash for living expenses, set it aside and exclude it from your portfolio. Over the long term, cash is a poor store of value so it should be put to work when opportunities arise, as they did in 2008-09 and August last.

Keep in mind that Australian interest rates could fall further, so don't expect cash to fund a long retirement.

Diversification reduces the role of luck, but that doesn't mean it always reduces risk.

Diversification won't save you if you're not buying cheap stocks, which is why valuation always matters. Nor will it save you if your portfolio is loaded with correlated risks.

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