Investment Portfolio Diversification: what is it? …and should you avoid over-diversification?
Investment portfolio diversification is heralded as the way to minimise investment asset class risk in the seeking to achieve financial goals. Some question whether this portfolio construction philosophy can be taken too far.
Is the diversification of your investment portfolio just a way for your financial planner to protect themselves (if it is in fact that at all!)? …or is it a valid tool for the design of your portfolio and selection of assets/ managers to achieve your strategic financial goals?
We reveal the elements that need to be assessed to ensure that your portfolio attains optimum outcomes – not mediocrity through over-diversification.
Elements to consider in investment portfolio diversification
Investment assets come in three basic classes: cash (including fixed income products such as bonds and other ‘cash equivalents’); property; and shares. Managed funds are used in the financial planning/ investment industry to capture specific elements of these asset classes – or in the case of most of the currently-available multi-blend funds, all of them.
- Why is your portfolio diversified? It all comes down to ‘risk’ and ‘reward’.
- How do you mix the assets to achieve your (long-term) goals? This depends on your appetite for investment risk.
- Does all of this diversification achieve results? Measured over any particular short-term period this is sometimes difficult to see; however, over the medium- to long-term, the consequently less volatile portfolio is expected to outperform the ‘undisciplined’ portfolio – and the investor should have a higher degree of ‘peace of mind’ in the minimised volatility that pervades their portfolio.
What investment characteristic and risk features attach to the different asset classes?
The following table gives some of them, looking at the investments as held directly –
|Asset class||Characteristics||Risk elements|
|Cash||Capital:stable within domestic economy. If in the form of bonds or fixed income, interest rate variation may generate growth or diminution in value. Liquidity: highly liquid as cash; usually very liquid as bonds. Income: interest based on perceived level of risk. Expenses: insignificant if any; unless recovery action undertaken. Taxation: interest earned subject to tax on full amount. Capital Gains Tax: not applicable||Capital:inflation can erode the purchasing power of cash over time; with bonds and fixed income instruments, default by borrower puts capital at risk. Liquidity: default by Bank/ borrower. Income: the borrower may default on payment; and market rates can vary. Expenses: where defaults occur, collection costs may arise. Taxation: rate will vary according to level of income of investor; no offsets. Capital Gains Tax: does not apply to this asset class|
|Shares||Capital:varies in value according to market perception; considered a growth factor over time. Publicly listed shares values available daily from stock market reports. Liquidity: usually very liquid – day of trade, plus 3 days for settlement. Income: business profits distributed as dividends according to cash needs of company. Expenses: buying and selling shares incurs a broker’s cost; and in some States in Australia may be subject to Stamp Duty on transfer. Taxation: dividends assessed in full; may be reduced by imputation credits on Australian share dividends. Capital Gains Tax: discounts may apply for shares held for longer than twelve months||Capital: ‘contagion’ effects can apply to shares in an industry in spite of individual sound fundamentals. Can rise/ fall quickly and without warning.Liquidity:may not realize full amount invested if ‘timing’ unfortunate. Income: can vary with economic circumstances, generally and for the company specifically. Expenses: these are usually ‘relatively marginal’ in most cases. Taxation: can be subject to regulatory change; or legislative change if fiscal management perceived by government of the day. Capital Gains Tax: able to be managed by careful planning when acquiring portfolio|
|Property||Capital: varies in value depending on market criteria. Liquidity: highly illiquid; usually at least 60 day wait – or sale term, plus 30-day settlement term. Income: from rent paid by tenants. Expenses: several fixed costs – such as Rates, Land Tax, Insurance; and variable costs – such as management, repairs, utilities, interest on borrowings; as well as obligations as property owner – compliance with statutes (registrations etc)Taxation: all income is assessable and all expenses offset – with a special deferment allowed for property value ‘depreciation’Capital Gains Tax: discounts may apply for property held for longer than twelve months||Capital:can be variable according to economic conditions, global industry issues, interest rates and regulatory action (such as rezoning of property or neighbours). Liquidity:subject to contract terms and conditions, purchaser capacity with finance and general market conditions. Income: periods of vacancy, or tenant default can impede cash flow. Expenses: tenants in certain industries can place higher demands on property than others; residential tenants can also be more or less caring of the rented property; as properties age, they may also require higher cost maintenance. Taxation: can be subject to regulatory change; or legislative change if fiscal management perceived by government of the day. Capital Gains Tax: able to be managed by careful planning when acquiring portfolio|
Blending in investment portfolio diversification
Each of the above asset types can be attributed a long-term average income; and each of the risks assigned a factor by which to determine the level of risk taken by making an investment in such an asset. The economic clock tells us that – in most circumstances (excluding the recent one-in-a-hundred-years event, commonly referred to as ‘the GFC’) – these assets achieve their peaks in income and value cycle at different stages of an economy’s development.
With that information in mind, it is possible to achieve optimum investment portfolio diversification to attain your realistic financial goals, using an appropriate blend of assets suited to your individual circumstances, within your lifestyle timeframe – and without exposing you to unacceptable investment risk.
What you need to do now –
The financial advisers at Continuum Financial Planners Pty Ltd are experienced in determining the appropriate wealth management strategy in your individual and family circumstances: ‘we listen, we understand; and we have solutions’ to your needs. To arrange a meeting to review your investment strategy – and the applied portfolio – phone our office (07-34213456) or use the Contact Us facility: we will respond promptly and courteously.