Episode 6

Not all returns are created equal; diversification (and over diversification), correlation and covering your butt

Welcome to Finance & Fury!
I’m sure that everyone’s heard the saying, “playing it safe” before. And in any game, it’s generally a good idea. If you’re playing a game or participating in anything, you want to make sure you don’t get kicked out of the game too early. And that’s where diversification comes in with investments. Its about covering your butt to make sure you don’t get kicked out of the investment game or at a certain point where it’s actually really essential to have your investments. We’ll be running through today; why even bother, how to get it right (because that doesn’t mean just spreading the risk around, it actually means increasing your returns as well) and then practically, how you can achieve that.

Spread the risk

  1. Risk measurement – volatility
  2. Correlation
    • Perfect correlated (move in the same direction by the same magnitude) – Australian to International about 80% or 0.80
  3. Think about it as how related things are in their movements together
    • For example, driving down the highway – cars going same speed in the same direction, measured as 1.00
    • Driving a bit slower: 0.90
    • Someone driving towards you, on the wrong side of the road – perfectly uncorrelated, maybe -0.60
  4. The important thing is coming up with the right mix of correlation between investments helps to protect you from downside risk.
  5. Last 20 years of returns

 

Best

Worst

Negative

Cash

1

7

0

Fixed Interest (Bonds)

4

5

1

International Shares

4

4

6

Listed Property

5

3 3
Australian Shares 6 1

4


Example:
Water flowing down stream. Rocks stay in place regardless of the direction of the water.
Salmon swim upstream against the current. The correlation between those three elements is a complete mess. If you’re investments are all over the place it’s really hard to get a targeted return.

Diversify! Focus on increase in value, not just returns

  1. Would you prefer an average return of 11.40% p.a. for 25 years or 10.20% p.a. for 25 years?
    • More is better? Not always…but why?
      Let’s say 11.4% is the return on an international share portfolio.
      25 years ago, you invested $10,000. This has now grown to $100,000. But! The returns are not compounding, they’re “average” returns! With compounding this would have been closer to $140,000 rather than $100,000. Some years you gained, some years you lost, some years stayed the same.Let’s look at the second half of that trick question. 10.20% average return.
      25 years ago, you invested $10,000 into an investment with a “growth” profile.

      • 40% Australian Shares
      • 40% International Shares
      • 20% Bonds (Fixed interest)

This would be worth $106,000 now! You made $6,000 more on an investment with a 1.20% lower average return.

  1. The downside movement has been reduced, which means even after an investment has dropped, you have more money still sitting there ready to go up.
  2. Would you prefer to get a 5% return on $100? Or 100% on $5? – it’s the same thing in value gained, but it’s the risk that varies.

You more you diversify, the more you have in investments – this shows progress

  1. The equations –
    1. You get more
    2. Can diversify more
    3. You get more out of that – plus it becomes safer

The process

  1. If you’re just starting out, you’re probably not in a position to just go out and buy 100 properties, along with a few million in shares, and build yourself a nice big diversified portfolio so it can be hard to get right at the start with limited assets.
  2. Where to start?
    • What have you go to work with?
    • What is the outcome?

How to determine what to invest in:

  • Risk tolerance
  • Required Return
  • Time horizon of investment

 

Just start!
How many investments:

  • First cover the bases mixing combination appropriate asset classes
  • Then, diversify within an asset class

Easy diversification
Having a diverse portfolio can be an expensive and timely to manage. Financial indices can help to solve this. A financial index is a measurement of the asset class (or market segment) it is representing. 

Australian Share indices

ASX20 – Top 20 companies (by market cap)
ASX200 – Top 200 companies (by market cap)
ASX300 – Top 300 companies (by market cap)
All Ordinaries – Top 500 companies (by market cap)

An index is a cheap way to provide diversification as it captures many investments in one holding.

Risks of diversifying and where it goes wrong!

  • Overdiversification – Can create a reduction in performance.
  • Making a reduction in standards of investments.
  • An increase in transaction costs.
  • Holding many of the same type of investment.
  • Not diversifying within asset classes.

In summary – Diversifying is awesome!

  1. Means you are buying more investments
  2. Grows your wealth in the process while protecting it
  3. As your ability to buy investments increases, your investments are more stable and secure
  4. Just start 😊

Finally, …thank you! The podcast has received tremendous support so thanks to you all. Great to hear all of your feedback and know I’m not talking to myself every week.

As always, questions and feedback, go to https://financeandfury.com.au/contact/

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