By Adrian Meager, General Manager Warwick Asset Management
Asset Allocation and Diversification
Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How do we learn these principles? The answer is through ordinary, real-life experiences that have little to do with the stock market.
Have you ever noticed that hawkers often sell seemingly unrelated products, such as umbrellas and sunglasses? This may seem odd. After all, when would a person buy both items at the same time? Probably never, and that is the point. Hawkers know that when it is raining, it is easier to sell umbrellas, but harder to sell sunglasses. And when the sun is shining, the opposite is true.
However, by selling both items, in other words, by diversifying the product line, the hawker can reduce the risk of losing money on any given day.
If that makes sense, then you will understand the importance of asset allocation and diversification within your investment portfolio.
Asset allocation involves dividing your investment portfolio among the different asset classes, such as shares, bonds, listed property, and cash. The process of deciding which mix of assets to hold in your portfolio is dependent on your personal circumstances. The asset allocation that works best for you will be dependent, inter alia, on your time horizon and your ability to tolerate risk.
When it comes to investing, risk and reward are inextricably entwined. You have heard the phrase “no pain, no gain”, this phrase can explain the relationship between risk and reward. All investments involve some degree of risk and if you intend to invest in shares, bonds, or unit trust funds it is important to understand that you could lose some of your money.
The reward for taking on risk has the potential for greater investment returns. If you have a financial goal with a long-time horizon, you are likely to make more money by carefully investing in asset classes with greater risk, like shares and listed property, rather than restricting your investments to assets with less risk, like cash. On the other hand, investing solely in cash may be appropriate for your short-term financial goals.
Shares, bonds, listed property, and cash are the four most common asset classes. But there are other asset classes available, for example, physical property, precious metals and commodities, private equity, and blockchain technology. Some investors may want to include these asset classes in their portfolios, however, investments in these asset classes typically have category-specific risks. So, before you make any investment, you should understand the risks of the investment and ensure that these risks are appropriate for you.
By including asset classes with investment returns that move up and down under different market conditions, an investor can protect against significant losses. Historically, the returns of the four major asset classes have not moved up and down at the same time. Market conditions that cause one asset class to do well often cause another asset class to have average or poor returns. By investing in more than one asset class, you reduce the risk that you will lose money and your portfolio’s overall investment returns will have a smoother ride.
Asset allocation alone will not necessarily diversify your portfolio. Whether your portfolio is appropriately diversified will depend on picking the right mix of investments.
A portfolio should be diversified at two levels: between asset classes and within asset classes. So, in addition to distributing your investments among shares, bonds, listed property, cash equivalents, and possibly other asset classes, you will need to spread out your investments within each asset class. The key is to find investments in segments of each asset class that may perform differently under different market conditions.
One way of diversifying your investments within an asset class is to find and invest in a wider range of companies and industry sectors. An investment portfolio which invests in only four or five individual shares will not be diversified. Your portfolio would need at least 15 to 18 carefully selected individual shares to be properly diversified.
Diversification can be challenging, so an investor may prefer to diversify within each asset class through the ownership of units in unit trust funds, rather than through the ownership of individual shares, bonds, etc. Unit trust funds make it simpler for investors to own a small part of many investments.
Be aware, however, that an investment in a unit trust fund does not necessarily give instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly-focused unit trust funds, you may need to invest in more than one fund to get the diversification you seek. To diversify within asset class, you may consider investing in funds with a larger company focus as well as some small companies and international shares or funds. Diversifying between asset classes may mean investing in equity funds, bond funds, listed property funds, and money market funds.
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you will likely need to change your asset allocation. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
Financial experts believe that determining your asset allocation is the most important decision you will make with respect to your investments, it is even more important than the individual investments you buy. So with all this in mind, talk to your Warwick Wealth Specialist to ensure you invest wisely and avoid costly mistakes.