Download Topic 3 – Why diversification is important

Topic 3 – Why diversification is important
Diversification is all about reducing risk by investing in
different areas and investment options. This approach is
necessary if you are serious about protecting your long term
financial situation.
If you want your investment to produce a reasonably
consistent income as well as grow and be protected from
inflation, you must make diversification a foundation of your
investment strategy.
By diversifying your investments across cash, property, fixed
income and shares you can create what is called a balanced
portfolio of investments, suitable for your tolerance for risk
and the return you want to achieve (capital growth and
dividends). A balanced portfolio will take advantage of high
returns whilst smoothing the volatility in the market.
The graph below demonstrates a balanced portfolio in comparison to different share market indices, New Zealand house
prices and a 90 Day Wholesale interest rate (bank interest rate). It also shows the average rate of inflation over this period.
The balanced portfolio is not achieving as high return as the share indices but the returns are a lot less volatile.
Relative Return from Key Investment Assets (NZD) September 1998 – October 2011
4000
3500
Australian All Ords
9.07%pa
NZSX All Gross Index
8.26%pa
Balanced Portfolio
7.46%pa
3000
2500
NZ House Prices
5.97%pa
Wholesale Interest
Rates (90 day)
4.04%pa
Inflation 2.51%pa
World Share Prices
0.41%pa
2000
1500
1000
500
Sep-98
Sep-99
NZSX All Gross
Sep-00
Sep-01
MSCI World Gross (NZD)
Sep-02
Sep-03
90 Day Bank Bill
Sep-04
REINZ NZ Avg House Price
Sep-05
Inflation
Sep-06
Sep-07
Aust All Ords (NZD)
Sep-08
Sep-09
Sep-10
Sep-11
Balanced Portfolio
Note: The NZSX All Gross Index is a gross index and from 1 October 2005 assumes the reinvestment of cash dividends. Prior to this date, the NZX gross indices assumed the reinvestment
of gross dividends (ie including imputation credits). The Australian All Ords Index is an accumulation (or gross) index and assumes the reinvestment of cash dividends. The MSCI World
Gross Index is a gross index and assumes the reinvestment of cash dividends (ie it does not include tax credits). The NZ house price return shown above does not include any income
that may have been derived from owning such property. It is purely a measure of capital return. The Wholesale Interest Rate return is after tax (now 30%). The Balanced Portfolio currently
comprises 10% NZ Cash, 26% NZ Bonds, 6% NZ Property, 20% NZ Shares, 19% Australian Shares, and 19% Global Shares.
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Investor Basics - Investing In Shares - 1/12
© Craigs Investment Partners 2012
Why diversify?
Reduce risk
Predicting and timing the market is difficult, if not
impossible and therefore sophisticated investors know
that diversifying your investments is crucial. It reduces
risk significantly without sacrificing much from returns.
Risk can come in many forms; inflation, volatility,
collapse in house market, currency movements, shift
in interest rates which can impact different types of
investments. Diversification is the first line of defence
against these risks.
Protect against uncertainty
Nobody knows how our economy
will perform in the future, what
markets will deliver the best or
worst returns, what inflation
will do, or in what direction
interest rates will move. The
only way to protect against
this uncertainty is to diversify
across a range of assets, markets,
sectors and securities. Diversification can be viewed as
an insurance policy against uncertainty.
Guard against inflation
Many people shun diversification into shares and
property altogether and prefer to keep all their savings
in term deposits. This might feel safer, but inflation is
the real enemy here which can decimate the spending
power of your savings over time.
Remove the need to time the market
The price you pay for shares, property, bonds and
currencies has a big impact on your future returns.
However, trying to pick the best time to invest is very
difficult because the future performance of markets
is unpredictable. Therefore it is absolutely critical that
investors not only diversify their investments but
also diversify their market timing by purchasing their
investments in instalments over a period of time.
For more information on asset allocation
and diversification please refer to Topic 9 of
our ‘Overview of Investing’ booklet.
Topic 4 – Why do share prices fluctuate?
Share prices are determined by how well a company is
performing. In general terms, if a company is growing its
profits (and therefore dividends) this will likely result in
an increase in the share price. However, it is important
to remember that there is no automatic link between
a company’s profit and its share price, as this is also
determined by supply and demand in the market place.
If investors get enthusiastic about a particular company
and start purchasing their shares, this can push the share
price up. Conversely if they become nervous about a
company’s performance and sell their shares, the share
price can drop.
Ultimately the supply and demand of a company’s shares
can be influenced by a number of factors:
1
1 The company’s current performance is crucial. If
the company is making a profit and either pays out
dividends or reinvests the dividends into the business
(to enable capital growth), this offers value to the
shareholders. Shareholders are less likely to sell and
more investors are inclined to buy.
3 A range of economic factors affect share prices and
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how they move including:
a Economic growth – is the economy growing?
b Overall consumer confidence and spending – if
confidence and spending is high, companies are
more likely to produce a profit
c Unemployment – high unemployment has an
impact on consumer spending
d Inflation – if prices of goods and services increase
due to inflation, this may suppress spending
e Currency – an increase in the New Zealand dollar
can benefit companies importing but would
have a negative impact on profits of companies
exporting
f Market conditions – if some markets are volatile
this can affect investor confidence and consumer
spending
g Interest rates – an increase in interest rates
usually cause share prices to weaken
2
2 The company’s future performance will determine its
future value. Any changes to the company’s future
earnings (its ability produce a future profit to pay
dividends and provide capital growth) will affect the
share price, so if forecasts look positive this is likely to
affect the share price positively.
© Craigs Investment Partners 20125