“Spread your risk” say the financial planners.
“Diversify your portfolio” say the stockbrokers.
“Don’t listen to them” says your editor.
The idea of having well diversified portfolios is probably the best piece of spin-doctoring to have come out of the funds management industry in the last twenty years.
By the same token, the cliché of “not having all your eggs in one basket” also makes sense. So, is there a middle ground? Of course there is. It is actively managing your investments.
The problem with well diversified portfolios is that they aren’t really well diversified at all. They tend to be diversified in the same direction. A managed fund split between Australian shares, international shares, property, bonds and cash isn’t diversification at all.
In fact, based on the current market, three out of five of those asset classes require a bullish market sentiment. And as for bonds and cash, well, they’ve pretty much neutralized each other. What you would’ve gained on the rise in bond prices you’ve lost on the falling cash rate.
When you diversify your portfolio too much across a single asset class or across multiple asset classes you tend to neutralize your returns.
For instance, what has a diversified portfolio done for most investors during the last eighteen months? Just take a look at the stock indices, that should paint a pretty clear picture of the damage.
Instead of investment managers preaching portfolio diversification, they should be telling clients to take a view and either stick with it, or have exit strategies if the view turns out to be wrong.
Of course, it’s not in the interests of fund managers to promote such a strategy. They want to convince you that managing investments is too hard for the average punter – leave it to them, your money will be safe in their hands… No thanks.
The key to investing really is to take a view and back your convictions. If you do that, and you’re right, then you’ll do much better than the average investor. If you get it wrong then you may do worse. But if you are actively managing your investments you can switch out of the investment if it moves against you. Traders do this all the time using stop-loss orders.
Let’s take the current market as an example. Last November when the S&P/ASX200 hit a low point, your editor – perhaps foolishly based on some of the emails we received – called the bottom of the market downturn.
Does that mean you should have gone in ‘boots and all’ to the stock market last November. No. We had a pretty important caveat, and that was the best places to look for share market investments are in the small cap sector and for those shares that are able to sustain a dividend payment.
In addition, our view was to stay away from finance sector stocks.
Four months later and little has happened to change that viewpoint. Let’s take the small cap sector as an example. Of course, we’ve a vested interest there thanks to our Australian Small Cap Investigator newsletter. But the facts speak for themselves.
Since the market touched its previous low point in November the S&P/ASX200 has fallen by a further 3.28%.
In comparison, the stocks in the ASI portfolio have gained by 16.59%. If you had diversified your portfolio across the whole market on the basis of market capitalization you would probably have received none of that gain in the small cap stocks.
As for the dividend paying stocks? Late last year we mentioned we were looking at releasing a new monthly newsletter based around income investing. We had put that on hold, but with interest rates slumping to record lows, we think now is the perfect time to unleash an income report onto the market.
I’ll let you know when more details are available, but hopefully we’ll be ready to launch in April. [Ed note: If you want to be among the first to find out about the new income service send an email to moneymorning@moneymorning.com.au and type "Tell me more about your income newsletter" in the subject line]
Yet if you take a view on a particular asset class or particular investments, it makes sense to back yourself. Providing of course, you are prepared to accept the potential downside if you’re wrong – that’s where your risk management strategy comes in.
If you believe the banking sector is grossly undervalued right now, why wouldn’t you load up your portfolio on bank stocks? Especially after CBA’s decision to maintain its interim dividend. But if bank stocks start to head further south then you’ve got to be prepared to cut your losses quickly. You can always jump back in again at a later date.
Unfortunately, the only risk management strategy that many investors use is ‘diversification.’ Considering that investing is supposed to be about getting wealthier, sticking to the convention of diversifying will only result in the fund manager getting wealthier while you see your investments barely keep pace with inflation.
Other Stuff on the Markets
The Dow Jones Industrial Average put on a bear market busting 5.8% overnight. The Nasdaq did even better, adding 7.07%. The reason for the rise? The opinion is that investors became bullish after seeing the letter sent by Citi Group CEO Vikram Pandit to staff on Monday.
You can read the full letter here – you’ll need to scroll forward to page 5. It’s natural for Pandit to talk up his own stock, but let’s not forget, the Citi Group share price is still on USD$1.45 with a market cap of USD$7.9 billion. It’s recently traded below a dollar and is on the verge of being classed a ’small cap’ company.
But, as I’ve mentioned above, if you think it’s been unfairly oversold, why wouldn’t you buy in at this price? There isn’t much downside left to it any more. Personally, we’d prefer to keep all the financials at arm’s length for a while longer yet.