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Asset diversification: why mutual funds add up

Asset diversification: why mutual funds add up.

Don't put all of your eggs in one basket!Don’t put all of your eggs in one basket!

In an investment environment where everything seems risky, diversification offers a relatively safe approach. Here’s how.

It was a wise man who once said: ‘Don’t put all your eggs in one basket.’ But what did he really mean? Well, if you drop the basket, you’ll break all your eggs. So spread your eggs around to avoid disappointment. In personal investment terms, this proverb refers to the reduction of risk achieved by investing in a variety of assets. In other words, diversification.

In this article I shall explore diversification in more detail, look at how to achieve it and whether it’s really possible at the current time for the standard investor.

What assets should be included in my diversified portfolio? In broad terms there are only six direct asset classes in the world that one can invest into. They are as follows:

1. CASH 
Legal tender or coins that can be used in exchange for goods, debt or services. Sometimes cash also includes the value of assets that can be converted into cash immediately. A significant risk of holding cash is inflation or even hyperinflation, often the result of a failed attempt to print money to avoid the deflationary measures that would be caused by austerity. Inflation or hyperinflation results in the collapse of buying power. So, as inflation rises, your cash can buy a smaller percentage of a particular good.

At the current time, three of the world’s major currencies – US dollar, pound and euro – are all viewed negatively due to their devaluation through significant quantitative easing. Nevertheless, cash needs to be part of your portfolio to provide liquidity for day-to-day living and unexpected rainy-day circumstances. A general rule of thumb is to keep a ‘cash cushion’ equivalent to three to six months’ income.

2. PROPERTY 
Good old bricks and mortar or even land. There are two reasons for owning property. First, you need some place to live. Second, for investment purposes, with the goal of generating profit either through income (e.g. rent) or through capital appreciation (e.g. profiting from a resale) or in most cases both. Risks and barriers for entry to owning property can include high deposit requirements (often 20% or more), volatile property prices, high mortgage repayments, inconsistent rental income, high maintenance costs and natural disasters. Property prices generally, after significant falls in 2009, have stabilised between 2010 and 2012. Property values have recovered in Asia and in London, but fundamentals remain weak elsewhere. Many should consider some specialised property assets, such as student accommodation (see my article in September–November issue of Property Life).

3. SHARES / EQUITIES / STOCKS 
An investment that refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains as the value of the stock rises. Of the various asset classes, shares arguably carry the most risk. However, ownership of shares in the right companies offers significant potential for financial reward. Like other investments, share ownership tends to follow a risk-versus-reward trade-off – in return for accepting greater risk, an investor who buys shares in a company anticipates the chances of financial reward will be greater than owning other types of assets such as bonds.

There are two major risks to shares, with one much more serious than the other. The lesser risk has to do with volatility, namely, the ups and downs of a share’s price over time. The other is the risk of losing some or all of one’s investment due to a serious and permanent decline in the business prospects of a company.

If you have an appetite for risk and the knowledge and time to monitor and research the companies to pick, shares should make up a proportion of your portfolio. There is one thing the 2008–2009 financial crisis has taught us, though – proceed with caution! Getting diversification within a share portfolio can be costly due to minimum board-lots (minimum purchase amounts, for example, of often 500 shares or more).

4. COMMODITIES
Economic commodities are regarded as goods and services. However, in the context of financial commodities (i.e. physical commodities), these are basic resources and agricultural commodities including iron, ore, salt, sugar, coffee beans, soybeans, aluminium, copper, rice, wheat, gold, silver and platinum. Soft commodities are those that are grown, while hard commodities are the ones that are extracted through mining. Another important class is energy commodities, which include electricity, gas, coal and oil. Personal direct investment in commodities is highly specialised and storage is also a huge problem. Prices for commodities are also hugely volatile.

As the world’s population continues to expand, shifting demand and constrained supply present significant opportunities. Precious metals (gold and silver particularly) act as a great hedge against financial instability and currency devaluation. For instance, the price of gold has been rising steadily since 2002 and is up over 400% in that time frame.

5. BONDS 
A debt investment in which an investor loans money to an entity (corporate or government) that borrows the funds for a defined period of time at a fixed interest rate. Thus, a bond is a form of loan: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Investors receive a higher interest rate for emerging market bonds to compensate for the higher risk of default.

Interest rates conversely are low for developed government bonds (e.g. 10-year US Treasury bonds currently pay at only 1.85%). The market price of the bond will vary over its life: it may trade at a premium (above purchase price) or at a discount (price below purchase price). Minimum investments are often $250,000+, so it may be difficult for the average private investor.

6. COLLECTIBLES / ALTERNATIVE INVESTMENTS
Perhaps the most varied and specialised asset class there is. This encompasses anything from fine wine, to art, to antiques and beyond and requires a huge level of knowledge and usually interest to act as a good investment. Like commodities, storage costs present a problem. Huge gains are to be had, but remember, would you want to sell your fine wine collection to realise a profit, or would you rather drink it?

Regardless of how you define an ‘asset class’, the important thing is that you (a) hold a variety of significantly different investments that are not highly correlated with each other and also that (b) your diversification within asset classes is to the degree at which the specific investment risk has been eliminated where possible. For example, an individual with a property portfolio of 10 London properties is not well diversified within the asset class.

The definition of a well-diversified portfolio is dependent on factors unique to the investor and typically defined by identifying the following: risk tolerance, target terminal wealth and investment horizon (planned holding period), amongst others.

So how can one achieve sufficient portfolio diversification by buying across the asset classes? Unless you possess huge knowledge, have plenty of time on your hands to monitor your investments, have sufficient storage capacity and are super-wealthy, it’s nearly impossible.

One approach of the regular investor (e.g. saving monthly) or for the investor with a moderate lump-sum is to look at mutual funds (or the UK term is ‘unit trusts’). These are popular with investors because they offer instant investment diversification. A mutual fund can be a mixture of cash, property, shares, commodities, bonds and collectibles managed by a team of professional investors. The professionals do all of the research for you, including picking and choosing assets that can achieve a desired ratio of risk and growth potential. However, mutual funds have their disadvantages, too. Not all mutual fund managers are created equal, so there’s no guarantee that your collection of stocks and bonds will make money.

Also simply purchasing one mutual fund might not give you adequate diversification – numerous mutual funds across asset classes will help aid diversification. For example, investing everything in an oil and energy mutual fund might spread your money over 50 companies, but if energy prices fall, your portfolio will likely suffer. Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors.

When you buy a mutual fund, you are able to diversify without the numerous commission charges. Imagine if you had to buy the 10–20 shares needed for diversification. The commission charges alone would eat up a good proportion of your savings. Add to this the fact that you would have to pay more transaction fees every time you wanted to modify your portfolio. With mutual funds, you can make transactions on a much larger scale for less money, because there are thousands of others just like you investing money into the same fund.

At a time where financial markets are in turmoil and individuals are unsure which way to turn, mutual funds can provide a good way to diversify your investment portfolio and ensure that you ‘don’t put all your eggs in one basket’.

By James Norman

11 December 2012

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This entry was posted on December 12, 2012 by in Investment, Property and tagged , , .

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