Overcoming a concentrated portfolio
Written and accurate as at: Feb 03, 2016 Current Stats & Facts
Link to Video
Video: Morningstar's Christine St Anne and David Simon
Video Transcript
Christine St Anne: Lack of diversification is often cited as one of the big mistakes made by many investors. Today I am joined by Westpac's David Simon, who talks to us about getting that diversification right.
David, welcome.
David Simon: Thanks, Christine.
St Anne: David, as a financial advisor do you find many people have a concentrated portfolio?
Simon: Not really. Most of the individual investors that I come across have a traditional, well diversified portfolio of assets. From time-to-time I do come across individuals that have a concentrated portfolio, but more often than not they are an executive of a company, which they held shares in, or they have a vested interest or a passion about the business that company operates within.
Interestingly, one of the world's, I suppose, most professional and successful investors Warren Buffet - he has a lot of quotes that are out there. But one that resonates quite well with this question. Buffet says, it's okay to have all your eggs in one basket as long as you watch that basket very closely. But I think that message was sent to more of the sophisticated investor that has a intimate understanding of that particular company and a real solid education about where that company is heading and what they are doing. But overall, most customers I see have a well diversified portfolio.
St Anne: So, what sort of assets should they look at to add more eggs to that basket?
Simon: Look there is a whole variety of assets that individuals can look at, but I think the underlying source of truth comes down to correlation. There is no point in diversifying across a basket of assets that are all going to be dependent on one another in terms of its own performance.
So ideally, we encourage investors to truly diversify in assets that are not particularly correlated or rely on one another. So, assets such as gold, commodities, cash, fixed interest, property, as well as shares have elements that are uncorrelated, which means they are not relying on each other increasing in value in order to generate performance. And you find that diversifying across this range of asset classes that are not particularly correlated means that if one asset performs and other one doesn't then the investor is not going to feel the brunt of the failing one. The other benefit he said it does smooth our returns by diversifying throughout the asset, and indeed you can diversify it within the asset close themselves.
So, for instance, the share market, you can diversify across a broad range of companies within different industries across different countries and you'll find that, that certainly allows access to opportunities, but also limits the risk of concentration.
St Anne: David, we are in the midst of unprecedented market volatility. What should investors do when one asset is not performing well, should they simply divest from that asset?
Simon: Yeah, look that's really interesting question. Investors need to first and foremost go back to the reasons why they made the investment in that asset in the first place and understand whether those reasons are still current and whether the fundamental characteristics of that asset are still present.
So, once they get through that then they need to understand the reasons of why they made that investment. So, did they make that investment for a short-term trading opportunity and hoping for a win or did they make that judgement on the benefit of a long-term investment objective rather than a trading opportunity. And then understand the asset deeply to work out whether or not the micro and fundamental characteristics of that asset still remains sound and that asset then still continues to have that quality component. Or indeed whether or not the reasons for underperformance are due to more macro noise-related events rather than the individual asset itself.
Once that investor understands this with these types of information, they then can determine whether it's still the right fit for their portfolio or not. But certainly panicking or making irrational decisions based on gut feel is certainly a very big risk to take.
St Anne: David, on that point of lack of diversification does this mean that many investors make the wrong decision when it comes to their life stage?
Simon: Look life stage is a very interesting one and it's very general in approach. We have clients that are well and truly in retirement, that say assets such as Australian Equities as a safe investment. We have some youthful people that have forty years before retirement, that say assets such as equities are the risky investments.
So, there is no right or wrong in terms of how individuals look at investments based on their lifestyle or life stage. But certainly generally speaking, typically a youthful investor that has years ahead of him before retirement and then generating sufficient cash flow out of their work to maintain their standard of living, typically they would forego the passive income that's attributable to investments in order to generate growth so that when they are at the point where they need income they can then draw income from their investments then. And progressively as our investors age then they move into an area where they are generating more income - passive income as the investor want on their employment to satisfy their income needs.
So, you'll find that life stage does invariably have some type of influence in terms of the assets in individual investing. And certainly in times like this where the market is particularly volatile and in distress, people are looking for more of a safe haven around defensive assets that have that ability to generate income, certainly whilst they are in retirement.
St Anne: David, thanks again for your insights.
Simon: Thanks, Christine.