diversification Archives - the patient investor

April 14, 2016

7 golden rules for SMSF investors

I found myself nodding in agreement when I read this list from Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital. I have added my comments in italics.

Investing during times of market stress and volatility can be difficult. For this reason it’s useful for SMSF investors to keep a key set of things – call them rules – in mind.

1. Be aware that there is always a cycle
The historical experience of investment markets – be they bonds, shares, property or infrastructure – constantly reminds us they go through cyclical phases of good times and bad. Some are short term, such as occasional corrections. Some are medium term, such as those that relate to the three to five year business cycle. Some are longer, such as the secular swings seen over 10 to 20 year periods in shares. But all eventually contain the seeds of their own reversal. The trouble with cycles is that they can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors when they are in or close to retirement. In saying this, cycles can also create opportunities.

Most important is to identify the long-term, secular trends that may last several decades and position your portfolio to take advantage of this. Examples of secular trends are the ageing population in developed countries; the rapidly expanding middle-class in India and China; and global warming. Sectors that may benefit from them are Health Care and Consumables.

2. Invest for the long term
The best way for most investors to avoid losing at investments is to invest for the long term. Get a long term plan that suits your level of wealth, age and tolerance of volatility and stick to it. This may involve a high exposure to shares and property when you are young or have plenty of funds to invest when you are in retirement and still have your day to day needs covered. Alternatively if you can’t afford to take a long term approach or can’t tolerate short term volatility then it is worth considering investing in funds that use strategies like dynamic asset allocation to target a particular goal – be that in relation to a return level or cash flow. Such approaches are also worth considering if you want to try and take advantage of the opportunities that volatility in investment markets through up.

Invest for the LONG term, otherwise invest in low-risk assets (cash and near cash) and not clever strategies.

3. Turn down the noise and focus on the right asset mix
The combination of too much information has turned investing into a daily soap opera – as we go from worrying about one thing after another. Once you have worked out a strategy that is right for you, it’s important to turn down the noise on the information flow surrounding investment markets. This also involves keeping your investment strategy relatively simple – lots of time can be wasted on fretting over individual shares or managed funds – which is just a distraction from making sure you have the right asset mix as it’s your asset allocation that will mainly drive the return you will get.

True.

4. Buy low, sell high
One reality of investing is that the price you pay for an investment or asset matters a lot in terms of the return you will get. It stands to reason that the cheaper you buy an asset the higher its prospective return will be and vice versa, all other things being equal. If you do have to trade or move your investments around then remember to buy when markets are down and sell when they are up.

Very important but this requires loads of patience, waiting for the right time to invest in the market.

5. Beware the crowd and a herd mentality
The issue with crowds is that eventually everyone who wants to buy will do so and then the only way is down (and vice versa during periods of panic). As Warren Buffet once said the key is to “be fearful when others are greedy and greedy when others are fearful”.

This is simply a repeat of Buy Low Sell High.

6. Diversify
This is a no brainer. Don’t put all your eggs in one basket as the old saying goes. Unfortunately, plenty do. Through last decade many questioned the value of holding global shares in their investment portfolios as Australian shares were doing so well. Interestingly, for the last five or so years global shares have been far better performers and have proven their worth.It appears that common approaches in SMSF funds are to have one or two high-yielding and popular shares and a term deposit. This could potentially leave an investor very exposed to either a very low return oif something goes wrong in the high -yield share that they’re invested in. By the same token, don’t over diversify with multiple – say greater than 30 – shares and/or managed funds as this may just add complexity without any real benefit.

Diversify into asset classes, geographic areas and strategies that have low correlation but don’t diversify into asset classes that offer negative real returns (after tax and inflation) or high risk relative to low returns.

7. Focus on investments offering sustainable cash flow
This is very important. There’s been lots of investments over the decades that have been sold on false promises of high returns or low risk (for example, many technological stocks in the 1990s, resources stocks periodically and the sub-prime asset-back securities of last decade). If it looks dodgy, hard to understand or has to be based on obscure valuation measures to stack up, then it’s best to stay away. There is no such thing as a free lunch in investing – if an investment looks too good to be true in terms of the return and risk on offer, then it probably is. By contrast, assets that generate sustainable cash flows (profits, rents, interest payments) and don’t rely on excessive gearing or financial engineering are more likely to deliver.

Most important. Invest in businesses with strong brands, patents or other competitive advantages that give them the ability to generate stable earnings over the long-term. Invest in stocks that you are likely to never sell but leave to the kids in your will. Occasionally you may sell one that falters but this should not affect long-term performance if you are well diversified.

Final thoughts

Investing is not easy and given the psychological traps that we are all susceptible to – in particular the tendency to over-react to the current state of investment markets – a good approach is to simply seek the advice of a coach such as a financial adviser.

Short-termism is the biggest danger to your investment portfolio. Too often I see investors do the exact opposite of what they should: buy high, when everyone else is buying, and sell low when everyone is a seller. Your best approach is to regularly consult an investment specialist.

Source: SMSF Suite – 7 golden rules for SMSF investors to keep in mind

May 14, 2015

Concentrated Portfolios: Do they enhance performance?

I mentioned last week that concentrated portfolios tend to outperform widely diversified portfolios in the long-term. This 2013 article from Money Management offers support:

Fund managers who invest in concentrated portfolios are able to outperform those who invest in diversified portfolios by 400 basis points, according to research coming out of the United Kingdom.

Investment skills consultancy firm Inalytics examined nearly 600 equity portfolios in its database and found that portfolios with the lowest quartile of holdings performed over 400 basis points better than the highest quartile of holdings.

Inalytics chief executive Rick Di Mascio said there were a number of explanations for the research findings including manager skill set, survival bias and greater attention being given to smaller equity sets.

“One possible rationale is that only the most skilful managers are given the punchier portfolios to run. A good analogy is that only the very best racing drivers get to drive Formula 1 cars.”

“Another explanation is that the database may be biased towards successful managers who were given the opportunity and ‘survived’. Once again there is a parallel with the Formula 1 drivers, but at least in the case of fund managers it isn’t dangerous,” Di Mascio said.

“Third, from a behavioural finance perspective, the literature suggests that the lower the number of holdings in the portfolio, the more attention each one receives.”

“Whatever the explanation, the data is clear — the more concentrated the portfolio, the more likely the performance is going to be good,” he says.

Our own research with momentum portfolios overwhelmingly indicates that greater concentration leads to improved performance. But this is no free lunch. With increased performance comes increased volatility. Which is why you need a long investment horizon when investing in concentrated portfolios.

July 26, 2014

Diversification – the only ‘free lunch’ in investing

Diversification is often referred to as “the only free lunch in investing” because it affords investors the opportunity to reduce investment risk without reducing returns. Most investments involve a trade-off between risk and return, with higher returns requiring investors to expose themselves to greater risk. But effective diversification allows investors to reduce risk, by spreading their investments, while maintaining higher levels of return.

What is effective diversification?

Not all diversification is effective. Many investors buy a wide range of stocks in the belief that this will protect them from risk. The benefits of such diversification are likely to be insufficient if the stocks are all listed on the same exchange and selected using the same method. The entire portfolio will tend to rise and fall in unison — as in the well-known adage “a rising tide lifts all boats.” The key is to select stocks or investments that have low correlation.

What is correlation?

Correlation is the degree to which separate investments rise and fall together. Correlation measures the tendency of investments to advance or decline independently of each other. The correlation coefficient, identified by the symbol r, expresses the level of dependency between two variables (stocks in our case). Values for the correlation coefficient range from 1.0, for stocks that are perfectly correlated, to -1.0 for stocks that move inversely to each other.

Only two shares of the same stock, like BHP Billiton, are likely to have a correlation as high as 1.0. But stocks from the same sector are likely to share high values. And stocks from the same market are also likely to share a reasonable degree of correlation in larger time frames (i.e. the primary cycle).

You are also unlikely to find stocks that are the perfect inverse of each other — a coefficient of -1.0 — except possibly from an index ETF and its bear counterpart.

We are not necessarily looking for stocks with negative correlation, however, but stocks or investments with low correlation — closer to zero than to 1.0. As you can imagine, going long and short the same stock would protect you from any variation in prices, but would not deliver much in the way of return. If we had a spread of investments with low correlation (i.e low dependency) their price movements will tend to offset each other, providing a smoother portfolio return.

3 Ways to achieve diversification

We are likely to find investments with low correlation using three different techniques:

Diversification by asset class;
Diversification by geographic location; and
Diversification by strategy.

Asset class

There are a number of asset classes available to investors. Asset classes as diverse as stocks, real estate and fine art, however, are all subject the vagaries of the economic cycle and tend to rise and fall together.

Bonds tend to have low correlation to stocks. We need to make a distinction here between government bonds with low risk premiums, which fluctuate largely with the interest rate cycle and tend to be counter-cyclical (i.e negatively correlated) to stocks, and corporate bonds which are subject to far higher risk premiums that may expand and contract in line with the stock market cycle. Credit spreads tend to be low when the stock market is bullish and widen sharply during a contraction.

There are other asset classes such as insurance funds, where risks such as weather events tend to have low correlation to the economic cycle, but investors need a fair degree of expertise to assess the risks associated with these investments.

Geographic location

Australian investors tend to be highly concentrated in the Australian market, with only about 15% of assets invested offshore, both directly and indirectly through managed funds. Most major stock markets tend to rise and fall together, but diversification, especially to US markets, affords investors the opportunity to diversify into sectors not available on the local exchange.

By strategy

Diversification by strategy is often overlooked. If an investor, for example, diversifies their stock portfolio across several value-based fund managers they are likely to find that their investments rise and fall in unison. Even though the managers may hold a wide spread of stocks, they are all selected using a similar process and will tend to behave in a similar manner.

By spreading investments across several strategies, the investor is likely to achieve more effective diversification and more stable returns. Diversification between value-based strategies and our own momentum strategy is an obvious example. Recent research shows ASX 200 Prime Momentum has a low correlation of 0.3368 with the popular Perpetual Industrial Share Fund [PER0011AU] and moderate correlation of 0.4263 with Colonial First State Australian Share – Core [FSF0238AU].

Diversification is not the only “free lunch” available to investors — effective tax planning also enables investors to enhance returns without increasing risk — but it is important and should not be neglected. It is a complex area and we recommend that you consult your financial adviser before taking any action.

The best argument for mutual funds is that they offer safety and diversification.
But they don’t necessarily offer safety and diversification.

~ Ron Chernow