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Portoflio Diversification - Downside and Risk

Mon, 11 Jun 2012 10:32:35 GMT

Portfolio Diversification – Risks and Downside

As pension funds and large endowment funds continue to reduce exposure to traditional listed equities in favour of alternative assets, many Investors and Financial Advisors are also reconsidering their asset allocation strategies in order to spread risk, reduce volatility and capture superior returns, whilst also reducing the correlation of their investments with financial market performance. In this post we look at some of the downside of portfolio diversification in order to present well-rounded view for the average investor.

Why should you diversify your portfolio?

Diversification is a vital tool used by Investors and Financial Planners to spread the overall risk of investing across a range of different asset classes. The basic aim of diversifying a portfolio is to ensure that all of ones eggs aren’t placed precariously in one basket, on the assumption that holding a variety of assets which derive returns from a variety of areas reducing the likelihood of multiple holdings all decreasing in value at once, or that some components of the portfolio might perform better in a downturn, offsetting losses elsewhere in the portfolio. This is of course a common sense approach to investing – one wouldn’t choose to bet everything on one proverbial horse! But as ever, there are also risks and costs which are not often talked about.

Costs of Diversification

When choosing to diversify your portfolio across a range of assets which might share little or zero correlation with each other such as listed equities, property, or alternative investments such as forestry investments, farmland investment, fine wine, art or gold bullion, the overall cost of maintaining the portfolio might well rise simply due to the number of different investments held. In the case of illiquid alternatives such as real estate, transaction costs can be much higher than with publicly-traded equity investments, and often specialised advice or professional services are required in order to identify suitable assets and transact on them - all of which eats into income or portfolio value.

My preference of course is for ‘real’ tangible, physical assets that retain capital value; are of a high enough quality to afford some kind of liquidity through open market disposal; and serve an essential or desired function – such as is the case with well-located real estate or productive agricultural assets. These types of assets tend to be more expensive to buy and sell than stocks and shares, so should be viewed as long term investments with little liquidity, and often such properties require continual cash inputs to cover taxes, maintenance, management and operation, and whilst income from these assets might cover such costs and provide a surplus during good times, there may be occasions when income is nil or limited, yet costs must still be covered.

Sufficient Knowledge

Holding a diversified portfolio of investments does not mean that your portfolio is ‘fire and forget’. Diversification does offer meaningful risk reduction when approached sensibly and with the individual investor’s circumstances in mind, but this risk reduction does not mean that you can sit back and forget about your portfolio. Holding a variety of assets ultimately means that you must become knowledgeable about all of the sectors in which you invest in order to react appropriately to changes in underlying fundamentals that support value and returns in those sectors. This knowledge will enable you to rebalance your portfolio when appropriate and stay ahead of the curve. For example, if you own a productive timber plantation, you must really be on the ball in terms of global and domestic supply and demand for timer, as well as prevailing timber price, in order to maximise returns and minimise risk. This will likely involve the retention of a skilled forest manager capable of making such decisions, and again, this incurs a cost.

Underperformance of Your Portfolio

One of the least mentioned and most relevant risks associated with portfolio diversification is the potential of underperformance. Investment is about timing; choosing the right assets at the right time and having the fortitude to allocate capital. The issue is that during any downturn, one particular asset class, or small range of asset classes will outperform traditional assets by some considerable margin. Oil; Bonds; Real Estate; Gold; Commodities; all of these assets have delivered spectacular returns at one time or another, especially when equity markets fall or crash as investor pile into safe havens. Investors with diversified portfolio reaped some of the benefit whenever one particular sector enjoys runaway success, but the irony is that this simply offsets losses in other holdings when an Investor is truly diversified. For example, investors holding gold and stock during the past four years have probably evened out, but investors heavily weighted in gold maxed out! So there is also a case to be made for choosing the right asset at the right time and placing a bet in the hope of capturing the forecast upswing in performance whilst at the same time reducing exposure to other assets. This of course is more of a profit strategy than a risk management strategy, and making the wrong decision or picking the wrong asset at the wrong tie could cost dearly.

In Summary

Holding a diverse range of assets is not a profit strategy, it is a risk reduction and volatility reduction strategy. If you are considering diversification, look to each individual investment on its own merits, and ensure you are capable of tolerating the illiquidity associated with investment alternatives such as real estate or other niche assets, and ensure you are aware of the long-term, on-going costs associated with management and maintenance. And most importantly, look to the fundamentals supporting value growth and ask yourself these questions:

  • Why is someone likely to pay me more in the future than I am paying today for this asset?
  • What kind of income will it generate?
  • What could affect consistency of the income (operating costs, demand etc)?
  • What are the costs of buying, managing and selling?

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