Diversification Dilemma

Diversification Dilemma

Article by Stephen Jones which featured in the recent Sunday Business Post Investment magazine highlighting how risk can impact on the diversification dilemma.


Many of us are not comfortable with risk — very simply, we don’t want to lose money.  We can see the result of this in the level of Irish household deposits, with a material increase having taken place since 2011.  However, this level of growth in deposits has been accompanied by a sharp reduction in interest rates over the period, and compounded by an increase in taxation (DIRT has risen from 27% to 41% not to mention the introduction of PRSI for the under 65’s from 1st January this year).  The result is that net deposit returns have more than halved over the period — the best 1 year rate is now netting 1.42% after DIRT.

The bad news is that this low interest rate environment is likely to remain for a protracted period. Therefore, we are faced with a dilemma — if we adopt a cash only investment strategy, we are looking at minimal returns for the foreseeable future.  To create the potential for higher real returns, we need to look at investing in other assets.

Understanding Your Risk Tolerance

A word of warning, before we look at other assets.  If you want to diversify, it is important to not alone understand what you are investing in and the potential and risks associated with such assets, but also to understand clearly your own risk appetite and your ability to sustain a risk investment strategy.   Your financial advisor should be able to provide this service to you.

It is a facet of human nature that the majority of us tend to invest in risk assets when confidence is high and after the markets have already risen significantly. Equally, we tend to dispose of risk assets when markets have fallen heavily and confidence has been damaged.  If we invest in this fashion (as many investors do), we will only obtain a fraction of what the markets are likely to deliver to long term investors.  If you can buy when there is value in a market (as opposed to when there is momentum in the market), and maintain that investment for a protracted period, then the probability of a positive return is markedly increased.

What Asset Classes can I diversify into?

If you have identified a need to diversify, the next question is what to diversify into.  Ideally, it should be into a combination of assets (including cash). It is critical to avoid a concentration of risk in one asset class, as this brings with it the risk of a specific event severely impacting your portfolio.

So what are the options open to me?

Traditionally, Government Bonds have been regarded as one of the most secure asset classes. However, European and US Government Bonds have seen a huge inflow of funds during the financial crisis — the result is that they are now generally very expensive, and offer very low returns.  Equities – over the long term equities are regarded as the asset class likely to provide the highest return. However, they are volatile in nature. As an example, since the turn of this century, the Dow Jones Eurostoxx 50 index has suffered two declines in excess of 50%.  Nonetheless, there is a real belief that against the backdrop of long term low interest rates, real assets such as equities and property are likely to prosper.  The very recent downturn in equity markets could be seen as the forerunner of a more significant decline. However, one thing is certain — stocks are cheaper than they were a week ago, and therefore if you are committed to building up an equity holding, it could be viewed as a buying opportunity for the first tranche of your equity portfolio.

The next question to consider is how you should invest in equities, and which markets should you invest in.  Buying direct equities may have a tax advantage currently (gains are subject to CGT), but you are taking on very specific risk when you buy individual holdings. Investing via funds (or in Exchange Traded Funds) is a means of obtaining wider diversification and therefore spreading your risk.  As for which markets to invest in, the last few weeks have demonstrated the volatility of investing in Emerging Markets, and if you are dipping your toe in the water for the first time, it may be best to concentrate on the developed markets of the US and Europe. The latter avoids a currency risk as well.

Turning to Property, we have seen a significant rise over the last year in the number of international investors buying Irish commercial property, and weak supply in Dublin also driving an upward movement in residential prices.  When you factor out the herd momentum, what we can definitely say is that there are some excellent yields on Irish commercial property relative to cash returns. There is therefore a case for some diversification into selective Property.  If you can invest in selective Property funds, which hold extensive property holdings in prime locations generating strong rental yields, and you can afford to hold these for the medium to long term, then you have a reasonable expectation of generating good returns based on the rental yield alone.  Conservative investors should be cautious of any property investment which entails borrowing (or leverage as it is termed) within the investment structure, as this magnifies both risk and potential returns.

In summary, low net interest rates will require many of us to look elsewhere for investment opportunities if we wish to obtain real growth in the value of our assets. However, if we are to diversify, we have to accept that the pursuit of higher returns, will bring with it additional risk. If we invest in risk markets, we need to adopt a diversified and long term commitment to these markets.