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Go forth and and diversify to make your money grow
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* May 3, 2008
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Smart investors spread their cash among all asset classes to get the best possible return, writes Simon Hoyle.
It is common knowledge - or it ought to be - that the cornerstone of successful investment is effective diversification. Diversification is the term used to describe the process of spreading your money among different asset classes. The aim is to combine the different characteristics of each asset class to generate the best "risk-adjusted" return - that is, the best possible return, for the lowest amount of risk.
The way you spread your money among the different asset classes is called asset allocation. Your asset allocation drives your investment portfolio's overall long-term return, but it also determines how much volatility, or risk, you are exposed to.
When your asset allocation includes a significant exposure to so-called "growth" assets (including Australian shares), and those assets are falling in value or lurching from one apparent crisis to another, the temptation can be to abandon the long-term asset allocation plan and head for the peace and quiet of something less volatile.
NOTE: STUDYING ASSET ALLOCATION NEEDS AWARENESS AND ENTHUSIASM TO CREATE GOOD GROWTH.
When investment conditions are rocky, it might feel like we're getting all the risk of equity markets, with too little of the return. But Chris Condon, chief investment officer for MLC, urges investors to stay focused on the future. He says the principles of sound diversification and strategic asset allocation that have stood investors in good stead for decades will continue to do so, despite the market's current gyrations.
"When you think about returns, what you need to be thinking about is the return you can reasonably expect to get in the future, rather than the return you have just received," Condon says.
"But the paradox for investors is that when you've had a period of very poor returns, that means the asset prices have gone down, and the earnings you are getting from the productive activities of the companies you are investing in will, as a proportion of the asset price … look like it has improved.
"But if, then, the markets chase the share price down even further because of momentum or sentiment, then your returns can look poor, even though you were expecting them to look good."
Symon Parish, chief investment officer, Australasia, for Russell Investment Group, says asset allocation and diversification decisions should be based on long-term data, not on movements in prices over three to six months. That means portfolios can be constructed to ride through periods such as the one we are going through.
"When we look at the theoretical side of asset allocation, and try to model how investment markets perform, you want to base that on as much data as possible," he says.
"So we look at the entire history of the sharemarket in Australia. The last five years have been unusual, not just in terms of how strongly the market has performed, but also for the low level of volatility.
"There's probably a lot of retail investors who haven't had the full experience of investing in shares, and how it works, in their minds, will be based on how it's been in the past five years.
"What we have seen this year, compared to the past five years, is extremely high volatility - but compared to the whole history of the market, it's not unusual. It's a little bit high."
NOTE: TRENDS CHANGES FROM TIME TO TIME.
The accompanying table, prepared by Russell, shows that over the 28 calendar years from 1980 to last year inclusive, the average annual volatility for Australian shares has been almost 22 per cent. But Parish says that in the past five years it's been closer to 10 or 12 per cent - unusually low.
Parish says investors whose diversification and asset allocation are soundly based on long-term data should have the confidence to ride out the current market volatility.
"They should stick to their guns," he says.
How the past looks, and what you think the future holds, can depend greatly on the moment in time you choose to look back from, and how you feel about the present.
For example, if you'd taken a moment in, say, early last November, to look back over time and to cast your thinking forward a few years, you might have come to a very different set of conclusions than if you undertook the same exercise today.
Back then, the equity market correction and subsequent volatility had not yet happened. The past looked good; the future looked rosy. But now the market has changed. In addition, interest rates have risen, and the whole investment world seems to have shifted on its axis. Your outlook, appetite for taking on investment risk and your expectations of likely future returns are quite possibly very different today from what they were six or seven months ago.
Even so, investment experts are quick to remind us that the benefits of diversification - of spreading your money among different asset classes - are no different today than they were towards the end of last year.
The table shows the returns and the volatility of a range of different asset classes and of notional investment portfolios over the 28 calendar-year periods to last year. The period includes the sharemarket crash of 1987, so it has some parallels with the present day, in the sense that it incorporates at least one significant market correction that had a profound effect on investor confidence (and arguably a greater one than the recent market turmoil).
The table reveals a number of interesting things about how diversification works over a long period of time, even when that period includes a market crash.
First, every asset class except for cash has at some point or other suffered a negative 12-month return. The asset classes with the highest long-term returns tend to have the greatest number of negative 12-month returns - that's in keeping with the investment principles that state you cannot achieve a return without taking some risk with your money, and the higher the return you strive for, the greater the risk (that is, the greater the chance of short-term loss).
At some point during those 28 years, each asset class has held the mantle of the best-performing asset class of all. And each asset class has also held the mantle of the worst-performing asset class.
The trouble for investors is that the distribution of best returns, worst returns, positive returns and negative returns is more or less random - which means picking, in advance, which asset class to invest in, and which to avoid, is more or less impossible.
So smart investors respond by saying, well, if we can't pick the best-performing asset class, and if we want to avoid being fully invested in the worst-performing asset class, we should spread our money among them all.
NOTE: NAME OF THE GAME IN ASSET ALLOCATION IS NEVER TO PUT YOUR MONEY IN ONE POT.
But it's not simply a case of picking, say, five asset classes and putting 20 per cent of your money in each. As the Russell table shows, different asset classes have different levels of risk. To work out the optimum mix of assets (or asset allocation), you have to understand your tolerance for risk, and then effectively "spend" this risk "budget" on buying asset classes in the right proportions.
Condon says there are two aspects to our risk tolerance. One is our physical or financial tolerance, and the other is our psychological tolerance.
These are not always easy to work out, and so it is best to analyse them with the help of someone who knows what they're doing. There are firms that specialise in analysing risk tolerance; all good financial planners will go through a risk-assessment process as part of a comprehensive financial plan.
"It really does come back to understanding your own tolerance for risk … where you are in your life cycle, [how much money] you need, and how soon you need it," he says.
"And secondly - and it's a separate question - understanding your own view of the amount of time you can bear, psychologically, [losses]."
Condon says financial tolerance is, simply, how much you can actually afford to lose. Clearly, you can afford to lose 10 per cent of your money more than you can afford to lose all of it. But you might not like the idea of losing even 1 per cent - and that's your psychological tolerance. It is separate from your financial tolerance, and it is often harder to determine.
It is possible to have a high psychological tolerance for risk, but a low financial tolerance (your entire wealth could be wiped out, but it doesn't worry you), or vice versa (a tiny fraction of your wealth is destroyed and you end up with sleepless nights and high stress levels).
The correct asset allocation takes into account both of these aspects, and will (if done properly) lead to a portfolio that gives you the best possible investment return without exceeding your risk boundaries. Diversification helps us, therefore, to optimise the return we get for the amount of risk we're willing to take.
As a crude example, the Russell table shows that an investment in Australian bonds returned an average of 10.3 per cent each year for the 28 years, with annual volatility of about 7.1 per cent. The table also shows that a portfolio holding 30 per cent growth assets (which Russell says is made up of 15 per cent Australian shares, 40 per cent Australian bonds, 30 per cent cash, 10 per cent international shares and 5 per cent property securities) had about the same level of risk - 6.9 per cent a year - but returned 11.5 per cent a year.
It means that for more or less the same amount of investment risk, effective and disciplined diversification delivered a 1.2 per cent a year higher return. Over 28 years, that is the difference between a $10,000 investment growing to $155,000 and it growing to almost $210,000 - a difference of $55,000.
The story is similar with international shares: over 28 years, an unhedged $10,000 investment in international shares grew to $263,000; a $10,000 investment in a portfolio with 50 per cent growth assets grew to $257,000 - but with less than half the volatility.
These examples illustrate why diversification was once described as the closest thing you will ever get to a free lunch when it comes to investment markets.
Condon says MLC applies the principles of diversification to its own managed funds, and will continue to do so, because the potential cost of not diversifying, or of making unwise changes to asset allocation in response to short-term influences, is simply too high.
"We've developed an asset allocation for [our] funds, and we do not make significant changes for what may be only short-term valuation effects," he says. "If you do that, you might be making the right decisions for the right reasons, but you cannot be certain that it will pan out correctly in a [given] period of time. It's very hard to be disciplined."
Hard, but often worthwhile: Parish says that on each of the past five occasions when the sharemarket has fallen by 20 per cent or more, it has rebounded strongly in the following 12 months - by, respectively, 38 per cent, 42 per cent, 50 per cent, 20 per cent and 26 per cent.
"If you get spooked, you can miss out," Parish says.
In any case, "it's a bit late now" to be thinking of abandoning your long-term plans.
"You've already taken the pain. If you wanted to get out, you should have got out last year. People should just get back in the saddle, as it were, and make sure they follow their long-term plans, and not get scared off.
"Often the best opportunities will come up when there's blood on the streets - that's when the real money gets made."
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