The Power of Diversification

When we think about companies raising money, there are two types of ways they can do this.

1. They can issue equity in their business in the form of shares, or;

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1. They can borrow, creating a debt. Companies sometimes borrow from a bank, but they can also borrow from investors in the form of bonds.
   
   

The percentage mix of equity and debt on a company’s balance sheet is known as the capital structure. Some companies have a lot of debt and they are said to be highly geared.

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Often the Industry the company is in influences its capital structure based on the efficiency of having more or less debt. Building companies, for example, often have quite a lot of debt which they repay on completion and sale of property projects.

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A company must always be able to pay the interest due on its debt to remain viable. If there is sufficient profit, after interest payments, a company can pay a dividend to shareholders and/or retain some earnings for use in the ongoing enterprise.

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In general shareholders, as the owners of a company, bear the business risk of that company. Debt (bond) holders usually have some security over the assets of a company and in the event of business failure, secured debt holders they rank before shareholders for the recovery of monies.

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So, in the first instance, there is some diversification that can be obtained by holding a mix of debt (bond) and equity (share) securities across different companies with different capital structures.

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What is diversification?

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Diversification is the process of determining the right mix of these different types of investments in asset classes, industry, sector, company, and investment terms to meet your investment return objectives – but also to do so with the least amount of risk possible. A portfolio with the lowest possible amount of risk and the best possible returns for that risk is said to be an efficient portfolio.

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Diversification should be something all investors think about. When done correctly, it will reduce the possibility of capital loss and can lower portfolio volatility.

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Many investors incorrectly believe that an index fund, tracking the largest companies in a particular country or region, provides diversification. Using the Australian ASX200 as an example, almost 50% of our market consists of just two sectors and only a few big companies; Banks (28.30%) and Mining (20.60%). So, there is not much diversification that can be obtained from this type of Index fund.

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What about other sectors? Other countries, emerging businesses, or different asset classes?

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No single investment should make you or break you. This means you should avoid concentrating your portfolio in any one type of investment exposure.

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So, it’s not just a matter of investing in multiple companies or types of assets but making sure they do not all operate in related industries, do not compete in the same market, or share the same correlation to risks or opportunities. Equally, diversifying too much can dilute your returns. Spreading capital too thinly may also have an opportunity cost, forfeiting returns.    

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Taking Full Advantage of Diversification Benefits

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Unlike many other investment firms which focus on Australian shares and residential property, our firm takes a global approach.

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When you think about it, Australia only represents about 2% of global financial markets. So, we see 98% of investment opportunity offshore.

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Our clients usually already own a house, a business, and/or they are well progressed with their career in Australia. Most are looking to build wealth outside and independently of their business or career. We refer to this as a “passive” investment.

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At Emanuel Whybourne, we invest in all major markets and asset classes. This includes:

• Australian Equities
• International equities
• Emerging markets or foreign markets
• Listed property
• Infrastructure
• Fixed income investments, such as government or corporate bonds
• Private equity
• Venture capital
• Foreign currencies

The average business or economic cycle tends to last between five to seven years. There will be a period of expansion where economic growth is rising above trend. There will be a peak (peak earnings, peak growth). There will be a slowdown or contraction, and then a trough where you will see falling growth and asset prices.

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Different countries in different sectors will perform differently throughout the market cycle. So being dynamic in how and where you allocate to asset classes throughout the market cycle, can significantly reduce risk, but also maximise opportunities.

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For example, following an economic downturn, monetary policy is normally accommodative meaning interest rates usually decrease to stimulate consumption and economic activity.

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In contrast, in an expansionary phase, interest rates usually increase. Understanding these dynamics, and where we are in the market cycle, allows us to take advantage of it by positioning your assets in a way that’s most favourable to where we are in that cycle.

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The Power of a Diversified Portfolio

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Diversification is important for investment portfolios, because it assists us to capture the opportunities available in the market cycle, as well as reduces the risk.

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A well-diversified portfolio avoids concentration of investments to any specific country, region, sector, industry or asset class.

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In our view, diversification goes a long way to helping you achieve your financial goals.

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It’s also my opinion that it’s important to note that there are different types of investment risks that investors need to be aware of when building a diversified portfolio. Some of the risks include:

• Investment risk: which we define as the risk of permanent capital loss
• Interest rate risk: as interest rates rise, this tends to have a negative effect on corporate earnings because the cost of capital goes up (debt repayments increase).
• Inflation risk: in a high inflation environment monetary policy may be changed to adjust for economic reasons.
• Market Volatility: the reality that markets move up and down over time. Subject to the particular investments and the different asset classes that you’re invested in, those movements will be larger or smaller depending on whether you hold a high growth or low growth portfolio

In my opinion, market volatility risk is the most important type of risk investors need to be aware of.

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Portfolios built for different risk profiles are going to carry different levels of volatility. In general, those who are willing to take higher risk will be subject to higher levels of volatility.

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Almost anything that our clients invest in should have little chance of permanent capital loss over the long term. So, when we define risk, we really mean volatility risk.

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This is why properly aligning your investment portfolio with your risk profile – as well as your time horizon – is incredibly important.

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An Investor’s Time Horizon

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If you’re investing for the short term, most of your portfolio asset mix should be diversified, but also quite concentrated to defensive assets. Some examples of these defensive asset classes include bonds and other debt instruments.

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Short term investors will have a lower allocation to growth assets (Australian, major International and emerging Market shares).

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The opposite applies for a high growth profile. You’ll typically have fewer defensive assets, fewer debt instruments, and more equity-type assets – which are more volatile but also offer the potential for higher long-term returns.

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How can you build a diversified portfolio?

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There are a number of different ways to create a diversified portfolio.

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Investing in a Broader Pool of Investment Markets

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Firstly, investing in a broader pool of assets in different regions – Australian equities, global equities, emerging markets – can help investors achieve portfolio diversification.

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Investing Across Different Asset Classes

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You can also choose to invest across different types of asset classes – equities, property, infrastructure, fixed income, currencies, alternative assets, private debt.

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Spreading your asset mix further will reduce the overall level of volatility within your portfolio. It also reduces risk, because each of those asset classes will perform differently in different stages in the market cycle.

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Investing Into Managed Funds

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Another way to diversify is by investing into a managed fund, or an exchange traded fund (ETF). Managed funds and exchange traded funds are a pool of underlying securities, as opposed to just investing in one share, overseen by a Fund Manager that has a strategy for their fund.

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In terms of diversification, it’s also important to take a whole of wealth approach, where you’re not just looking at diversity by holding a large number of investment but you are also looking at your concentration to any one particular sector or asset type.

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Key questions for your overall wealth position are:

• How much cash do you have in the bank?
• How much of your wealth is concentrated in your personal property or business?
• Does the revenue that is derived from your business come predominantly from the Australian market or offshore?

In our view, taking an overall wealth approach is incredibly important.

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Most of our clients are private business owners and like most private business owners, they’ve accumulated a significant asset in that business which typically represents a substantial part of their wealth – excluding their main residence or commercial properties attached to their business.

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So, a challenge for many of our clients is: How can they diversify into an asset that meets their return objectives and their investment objectives to generate wealth which is independent of their business?

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As a business owner, there are numerous risks.

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There are risks that the regulation around your business changes. There are risks that the needs of your consumers will change throughout the lifecycle of your business. There are risks of retaining key staff members and there are risks that technology will change and disrupt the way that your business is carried out.

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So, for our clients, building a passive investment asset – which is both diversified and aligned to their risk and return objectives – is incredibly important. That is something we do very well at Emanuel Whybourne.

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If you’re interested in exploring how to diversify your wealth, and how to build a passive investment entity that gives you and your family financial security, talk to me or any advisor at Emmanuel Whybourne today.

Until next time,

Ryan

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