Download Asset Allocation and Diversification

Asset Allocation and Diversification
Aim to get the right eggs in the right baskets.
Asset Allocation is a term that describes how
much money you have invested in each of the main
investment asset classes; Cash and Fixed Income/
Interest, Property and Shares/Equities. How you decide
to split your investments between these categories will
determine your future returns, and more importantly,
the level of risk you will face.
The spread across these different asset classes (your
asset allocation) will vary depending on your risk profile.
For example: if you are a conservative investor and
don’t want to take a lot of risk, your portfolio would
contain a larger percentage of cash and fixed interest
and less shares/equities.
In New Zealand, our most popular investments are our
house, business and term deposits, and we tend to have
a great deal of our total wealth tied up in these few
assets. Investors who don’t want to take excessive risk
by “putting all their eggs in one basket” however need
to diversify their investments.
Diversification by Sector
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 longterm financial situation.
For example, within shares, an investor will usually hold
securities within a number of different companies and
sectors.
If you want your investment to produce a reasonable
income as well as grow and be protected from inflation,
you must make diversification a foundation of your
investment strategy.
The below charts show how a portfolio may be
diversified across asset classes, sectors as well as
geographies.
Diversification by Asset Class
The first, and most important way to break
down your portfolio is by asset class;
•
Cash
•
Fixed Income/Interest
•
Property
•
Shares/Equities
Diversification by:
Asset Class
Diversification by:
Sector
It is standard investment practice to spread risk by
diversifying your investments across different assets
as well as across a number of investments within each
asset class.
If one sector is performing poorly, other well performing
sectors can generate income for your portfolio and
thereby promote more stable returns.
It is important to be aware that industries are influenced
differently by external factors.
The building industry for example is largely influenced
by the general economy. If the economy is in decline,
perhaps even in recession, there will be no demand
for new houses and construction companies will be
impacted. Since the company would be performing
poorly the value of the company would fall including
the share price.
Companies within infrastructure rely on government
spending and if the government decides to divert
money from infrastructure, these companies will be
affected negatively.
Sector
 Infrastructure
Examples of companies in
each sector
Auckland International Airport
Diversification by:
Geography
 Transportation Mainfreight
Fixed
Interest
Property
Shares/
Equities
 Port
Port of Tauranga
 Healthcare
Fisher & Paykel Healthcare
Ryman Healthcare
 Energy
Meridian Energy
 Property
Kiwi Income Property
* Above sectors are companies listed on the NZX
as at 31.08.14
Australia
NZ
Em
M ar erging
ke t s
Cash
Global
These proportions are for example only
and does not reflect appropriate or
recommended asset allocation.
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Due to the differences between sectors, it is important
to diversify your portfolio to manage the risks within
each of the sectors.
Diversification by geography is also important in
order manage risk and mitigate the impact of poorly
performing markets, whilst taking advantage of better
performing markets. Whilst one country may be in
decline, another might be enjoying growth and this can
help provide positive returns.
Diversification by Geography
Certain sectors may be stronger in some countries than
others, and therefore it is important to look at, not only
what sectors to invest in, but also where.
Who will do better?
The Question
Who will do better, Investor A who achieves a 10%
return every year for three years or Investor B, who
enjoys two years of 100% returns and then one year
of negative 68%?
45000
40000
The Answer
35000
30000
$ Amount
example, this may require you to invest in Australian
and global shares. This is because most banks operating
in New Zealand are Australian owned and listed on the
Australian Exchange. Therefore, by investing overseas
you will get exposure to a different economy and
sectors, which may not be available locally.
A poor performing economy may impact retail sales
whilst commodity prices will remain steady or perhaps
even increase. This is because commodities are not as
influenced by general demand. Even if the economy is
poor, we will still need petrol (crude oil) for our car.
25000
Investor A
$13,310
20000
15000
10000
The below chart shows an alternative way in which a
diversified portfolio may be structured across different
asset classes, sectors and geographies.
In New Zealand we have a strong primary and energy
sector, but to gain exposure to the banking sector for
Investor B
$12,800
5000
0
1
2
Year
3
Source: Craigs Investment Partners, September 2014
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$10,000 invested for three years at 10% will grow
to $13,310. The same amount will grow to $40,000
after two years of 100% returns, but will then drop
to just $12,800 after the third year’s loss of 68%.
The Lesson
Slow, steady returns beat fast, volatile returns over
the long-haul- another example demonstrating the
importance of a diversified portfolio.
A Diversified Investment Portfolio
Asset Class
Cash
Fixed income
Company
Financial
Genesis
Geography
Shares
What ever you do - diversify!
Energy
Sector
Property
NZ
Commercial
Kiwi
Income
Property
Westpac
AUS
Residential
Stockland
NZ
AUS
Healthcare
Energy
Infrastructure
Fisher &
Paykel
Healthcare
CSL
Meridian
Energy
Santos
Auckland
Airport
Sydney
Airport
NZ
AUS
NZ
AUS
NZ
AUS
The future performance of markets is uncertain and risks that could potentially threaten the value of an
investment portfolio are unforeseeable. Diversification helps protect investors against this uncertainty. Risk
comes in many forms and history has shown time and again that a diversified investment portfolio is the best
protection against risk, wherever it comes from.
Relative Return From Key Investment Assets (NZD)
September 1998 - June 2014
As the graph shows,
markets can be volatile
due to many reasons and
performance can vary by
wide margins, both over
the short-term and also
over longer time periods.
The balanced
(diversified) portfolio (in
red) has not achieved
as high returns as
Australian or New
Zealand shares but
has remained relatively
stable in comparison.
This illustrates the
importance of
diversification.
5000
NZSX All Gross Index
10.02%pa
4500
4000
3500
Australian All Ords
8.40%pa
3000
Craigs Balanced
Portfolio
7.57%pa
World Share Prices (USD)
6.31%pa
2500
NZ House Prices
6.27%pa
2000
Wholesale Interest
Rates (90 day)
3.71%pa
1500
World Share Prices
2.60%pa
Inflation
2.25%pa
1000
500
0
Sep-98
Mar-00
NZSX All Gross
Sep-01
Mar-03
MSCI World Gross (NZD)
Sep-04
90 Day Bank Bill
Mar-06
Sep-07
REINZ NZ Avg House Price
Mar-09
Inflation
Sep-10
Mar-12
Aust All Ords (NZD)
Sep-13
Craigs Balanced PF
MSCI World (USD)
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
he reinvestment of cash dividends. The Craigs Balanced Portfolio is included as an example of a diversified
portfolio. 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%).
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Asset Allocation and Diversification – 09/14
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8 Reasons why we should diversify our portfolios
1.
ecause diversification is the only free lunch in
B
the investment world. Sophisticated investors
know that a high proportion of speculators fail
(we hear only of the very few who strike it lucky)
and they know that the only free lunch in investing
is diversification. It reduces risk significantly
without sacrificing much from returns. Nothing
else in investing comes close to offering as much
“bang-for-your-buck”.
2. B
ecause nothing is certain in the investment
world. There are no facts in investing; only
forecasts, historical data, theories and judgement.
Nobody knows how our economy will perform in
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 diversification across a
range of assets, markets, sectors and securities.
Diversification can be viewed as an insurance policy
against uncertainty.
3. B
ecause the extra return you might earn from
concentrating your portfolio is not worth the
risk. In the past, over the long term, shares have
returned about 10% a year, property 9%, fixed
income 6% and cash 4%. A balanced portfolio
has typically returned an average return of 7%
to 8% a year, which is only marginally less than a
portfolio concentrated in shares or property,
with far less risk.
4. B
ecause the lower return you receive from not
investing can leave your capital exposed to
inflation. Many people shun diversification into
shares and property altogether and prefer to keep
all their savings in term deposits. This feels safer,
but such a portfolio will probably earn 2% to 3% a
year less than a balanced portfolio. That doesn’t
sound like much, but that’s about the annual rate
of inflation, and inflation can erode the spending
power of your savings over time.
5. B
ecause market timing is very important, but very
difficult. The price you pay for shares, property,
bonds and currencies has a big impact on your
future returns. As the saying goes, it is better to
‘buy low and sell high’. However, trying to pick the
best time to invest is very difficult because the
future performance of markets is unpredictable.
We therefore believe it is absolutely crucial that
clients not only diversify their investments but also
diversify their market timing by purchasing their
investments in instalments over a period of time.
6. B
ecause risk comes in many guises. Risks
are by definition ‘unforeseeable’, and are also
unquantifiable. Some examples of risks that
portfolios need to be protected against include a
sharp increase in inflation, a period of Japanesestyle deflation, extreme stock market volatility, a
collapse in house prices, credit risk and corporate
failures, dramatic currency movements, a significant
shift in interest rates either up or down, a lack
of liquidity and inability to exit investments,
asset bubbles and changes to government or
government policy. Diversification is the first line of
defence against risks such as these together with
the myriad of other risks that face investors.
7. B
ecause most investment disasters are caused
by a lack of diversification. When you look
at instances where investors have suffered
catastrophic and permanent capital loss, perhaps
two-thirds or more of their life savings, a lack of
diversification is almost always a contributing
factor.
8. B
ecause diversification doesn’t mean buying
a ‘rent-a-crowd’ portfolio. There is no need to
consider sub-standard investments simply because
they enhance diversity. Stick to quality for core
holdings and only buy investments that meet your
quality and income requirements – just aim to own
as many of those as you can.
This is general information only. The examples are provided as an illustration and are not intended to represent any indication of future
performance. Investments are subject to risks and their value can go down as well as up. Before making any investment decisions we recommend
you seek professional advice. While this information is considered reliable its accuracy and completeness cannot be guaranteed QuayStreet Asset
Management Limited, its related companies and their respective directors and employees do not accept liability for the results of any actions taken
or not taken upon the basis of this information or for any negligent mis-statements, errors or omissions.
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Asset Allocation and Diversification – 09/14