Investment Diversity is as important as Biodiversity
One of the constant features of us complicated humans is the desire for diversity. We get bored quickly. We want new tastes, new experiences, new ‘stuff’. As soon as anything becomes repetitive we lose interest or get stressed. Repetitive jobs, reruns of old TV shows, repetitive ads, poor menu choice at your favourite restaurant. Fashion is a direct result of our need for variety. In nature this variety is called biodiversity.
Biodiversity is extremely important for the planet. It allows for flexibility when change happens to an environment. That change may kill one or two species, but something will always survive – even if it is just a cockroach or Trump. When it comes to our wealth, diversity is just as important. You cannot afford to put all your retirement eggs in one investment basket.
So let’s look at the various components of wealth and see where the diversity can come from:
There are 5 asset classes: Cash, Bonds, Equity, Property and Currency (not a classic asset class but a multiplier for offshore investments).
Cash is pretty self explanatory. It is ‘boring’ and gives you a below inflation rate of return. It’s importance to your wealth however cannot be underestimated. Cash-flow is king, not just for businesses but for individuals too. If you have cash available you can weather unplanned expenses without taking out expensive debt. You can also take advantage of other wealth opportunities quickly and without eroding your other wealth caches. If you put your cash with a major financial institution or in a product that spreads the risk across a number of institutions you are going to be okay. You are unlikely to lose the capital. What percentage of your wealth portfolio should be in cash? This is going to vary according to the economic environment but 3 months, after tax household expenses plus 10% is a reasonable rule of thumb. This is right across your wealth portfolio. Your retirement fund for example will have at least 10% in cash – but is ‘unavailable’. If you have a ‘blended’ unit trust (a flexible or moderate mandate for example) then there is probably a cash component there too.
Bonds are the least understood asset class. Most of us rely on professional asset managers to determine what percentage of bonds should be in our portfolios. Globally bond yields are at historical lows, but in emerging markets, like our own, they are significantly higher because of the perceived risk. Asset managers in retirement funds and income funds use bonds effectively to hedge risk in blended portfolios.
Property is classically listed (commercial) property, but for an individual this is definition much wider. For many of us our home probably makes up the Lion’s share of our wealth, less so when you just consider the ‘equity’ you have in the property (what is left over when you subtract the potential proceeds (minus all costs) and your mortgage bond. Your home is a ‘lifestyle’ asset – you are unlikely to be getting any income from it. By having a property though your wealth is exposed to this ‘risk’. Of course there is the potential of adding a rental property portfolio to your wealth. I have gone into this in more detail HERE, so I am not going to repeat myself. Property as an investment has 2 components, the capital appreciation (about 6% pa historically) and the rental income (between 4-8% depending on location). It also has significant ‘management and maintenance’ costs that can run to several percentage points. While a listed property portfolio value may oscillate almost as wildly as an equity portfolio, if you own the property then even if you lose your rental tenant, it is highly unlikely that you will lose the entire property due to the market (outright loss by fire for example can be insured). In other words that ‘capital’ component is safe. If you think that rental property is ‘passive income’ think again. This asset classes is high maintenance and either you do it yourself, or you pay someone else to do it. It should also be carefully constructed with your financial and tax advisors to minimise the tax implications in the short and long term.
Equities are the potential gems of your portfolio. They are going to give you the inflation-beating growth that everyone wants. They do come with the potential for volatility and of course outright loss. The JSE Allshare index tanked 28% during the credit crises, some shares tanked completely, never to recover. I am not even going to start talking about options or futures where you can lose the capital and more. If you have a share portfolio, it must be well diversified to hedge the risk. If one or more shares go extinct, then at least the portfolio survives. The elephant in the room is fees. These are the equivalent of an insect infestation in your veggie patch. If you are paying an asset manager/stock broker fees on your equity portfolio it is to beat the market. If they don’t, after fees, then why are you bothering? Why not buy trackers or ETFs and be proudly average?
Unit Trusts (they keep trying to get us to call them Collective Investments with limited success) are a good way to get diversification and come with the added protection of being a Unit Trust that you will not get when you place the funds directly with a stockbroker. Basically your funds are taken out of the control of the asset manager and placed with another financial institution (who acts as the trustee) so that they don’t get ‘lost’. That trustee has to be completely independent of the fund manager. That is why you will see on your Investec investments, Nedbank is used. The Trustee will also make sure that the investment mandate is adhered to. For example if a mandate states 95% local equity, then the asset manager cannot deviate from that – even if he thinks the market is going to fall off a cliff (hence my preference for flexible equity mandates). If that asset manager goes out of business, your funds are safely held by the trustee. The asset manager has no access to the funds at any time (there used to be a suspense account that they could dip into but no more). This layer of protection of course comes with a fee, but if you shop around it need not be much more than you would pay for going ‘direct’. ETFs have also been unitised, giving them the same protection but at a far lower cost than an actively managed fund.
It is possible to over-diversify. If your advisor has put your portfolio into seven or so different funds understand it is basically to keep him out of trouble. The more diversity, the better the chances you are going to get the market average -and that is not necessarily a bad thing. There are better ways to be proudly average – use a unitised ETF and put the fee saving on the bottom line.
Action: It is very important that your retirement cache of wealth be diversified. If you’re lucky enough to have a chunk left over that is just a legacy then you can do what you like with it (but the psychological effect of its volatility might still bite). Obviously the first step is to determine just what your retirement requirements are going to be and to split off your required funds from your legacy.
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Author Dawn Ridler ©