Concentrated investments add to risk but have no expected extra return
Our previous article in our series on the Personal Financial Dashboard – a graphic format that succinctly captures the journey to, arrival at and maintenance of financial independence – examined the rationale for setting a target maximum growth asset allocation. And, as a corollary, a minimum defensive asset allocation.
This article looks more closely at an aspect of how both growth and defensive assets should be held in order to increase the chances of both becoming and remaining financially independent. It is the focus of Chart 6 of the Personal Financial Dashboard, the Diversification Ratio.
When you are relying entirely on your investment wealth to finance your desired lifestyle for an indefinite period, it’s generally not the time to take more investment risk than you need. While you may wish and require your wealth to grow, effective wealth management should largely be about ensuring that in the quest for higher returns unnecessary risk is avoided.
And the most common way that investors take unnecessary risk is by holding a significant share of their wealth in a small number of investments e.g. one or two investment properties, a handful of Australian shares. On average, an individual investment will only perform as well as the asset class of which it is a member (e.g. Australian shares, international shares, Australian residential property). But an individual investment may perform significantly worse or better than its relevant asset class.
When wealth protection is a major concern, it doesn’t make sense to expose yourself to the possibility of significant underperformance of an individual asset that can easily be avoided by holding the entire asset class. This is the rationale that underpins the old risk reduction adage that urges you not to put “all your eggs in one basket”.
But the additional financial rationale for spreading risk broadly, or diversifying, relates to the fact that individual assets carry two types of risk – risks related purely to the particular asset (i.e. non-systematic risk) and risk related to the relevant asset class (i.e. systematic risk).
For example, when the inspirational Steve Jobs died there was great concern for the future of Apple. However, his death had much less affect on technology shares, in general, and negligible impact on the US share market, in total. Key man risk is clearly a company specific risk that may lead to poor investment returns regardless of what the total share market is doing.
Financial economists argue that you can’t expect (i.e. on average) to be rewarded for taking asset specific risk (e.g. betting on Steve Job’s survival, in the case of Apple) when it can be eliminated by diversifying broadly both within and across asset classes. You can only expect to be rewarded for risk that can’t be diversified away i.e. broad market or asset class risk.
The more investment diversification the better …
Either deliberately or unwittingly taking concentrated or non-systematic investment risk, that offers no expected additional return for the additional risk, is inconsistent with our view of becoming and remaining financially independent. Therefore, an important indicator of financial independence is the extent to which your investment assets are well diversified.
Chart 6 of the Personal Financial Dashboard, the Diversification Ratio, measures the percentage of your total investment assets that are diversified, with 75% regarded as a minimum benchmark for financial independence. For us to classify an asset as diversified it generally means that it is a managed or exchange traded fund, with the fund holding a large number of or even all the assets that comprise the asset class (e.g. an Australian or global share fund).
Provided it can be achieved cost effectively, we suggest more diversification is always better than less. Clients are sometimes surprised when we categorise a large deposit with an individual bank as a concentrated or undiversified asset. We argue why should credit risk be taken on an individual bank when it can be spread across many banks and government backed instruments through appropriate short term fixed interest funds.
Shown below is the Johnson’s (as referred to in previous articles) Diversification Ratio chart. It records changes in how their investment assets were held since becoming clients in 2001:
It reveals that the Johnsons had a reasonably well diversified investment portfolio when they first became clients and steadily increased their level of diversification until 2012. However, the inheritance of a relatively large but poorly diversified Australian share portfolio saw the Diversification Ratio drop sharply in 2013.
Disciplined sell-down of about 50% of this portfolio and reinvestment into appropriate broadly diversified managed funds over the past 12 months has seen the ratio again rise to almost benchmark levels. It is projected that diversification will continue to increase over the next five years.
Where are you on the road to your financial independence?
That completes our series on the six charts that comprise the Personal Financial Dashboard and its application to our client, the Johnsons. Their complete Dashboard is repeated below:
On all indicators, the Johnsons are now in pretty good shape. If they’re not already financially independent, they’re very close to it. But it hasn’t happened by accident.
The readings on all charts in 2001 suggested they were a long way off their objective of financial independence. But a clear picture showing unambiguously where they were compared with what financial independence looked like made it obvious that serious changes in their financial behaviours were required. They then committed to making those changes over an extended time.
Unfortunately, while many people crave financial independence, most don’t know where they are on the road to its achievement or what it looks like for them. They have no idea what, if anything, needs to change.
Together with the Personal Financial Dashboard, this lack of awareness is the catalyst for a new service that we now offer called “wealthcheck“. It is discussed in our next article.
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