Here’s why diversification matters…

Last week, I suggested we’d all be wise to temper our return expectations this year. Markets don’t go up in a straight line, and after nearly seven years of (mostly) rip-roaring returns, things are stuttering a fair amount.

After the first two trading weeks of the year, it’s far to say there’s a lot of nervousness in the air. Already, the ‘return of capital, not return on capital’ cliché is being rolled out. And investment houses, like RBS are advising clients to “Sell everything except high quality bonds…. In a crowded hall, exit doors are small.”

Even before the chaos really took hold last week, I suggested that a 10% annual return over the next year or two would be my aim. Achieving that would be a very good result. And as we hurtle towards the end of month one with indices entering bear market territory across the globe, suddenly 10% looks like a pipe dream.

Still, many local investors are effectively banking on a markedly weaker currency by the end of the year, repeating calls from analysts of R19:$1 and R20:$1 as fait accompli.… There’s their return, simple. I’m particularly worried during times like this, when practically every single analyst/economist/financial adviser is parroting the same advice. If it’s this easy, their portfolios are already all >30% better off at the end of 2015 than they were at the start of the year, no? And by the end of this year, they’ll surely be up another 20%?!

This is not to say that the rand won’t finish 2016 at the levels being bandied about, but this is an awfully risky investment strategy, no matter how easy it was last year (perhaps, even, in hindsight). Problem is, global equity markets aren’t exactly compelling investments at present. They’re mostly significantly down in the year-to-date and most had very average/flat years last year.

Some thinking, reading and portfolio planning over the holidays saw me turning to a graphic produced by Sanlam Investments, one which I remember clearly from a presentation by the brilliant Alwyn van der Merwe of Sanlam Private Investments (now Sanlam Private Wealth) a good few years back. I found my filed printed copy which was woefully out-of-date.

Here, then, is something that every investor should print out as a reminder about diversification – one of the golden rules of investing:

Local market | One-year asset class returns December 2015

t1Source: Morningstar, Sanlam Investments.
Proxies for Diversified Portfolios: (ASISA) South African – MA – High Equity | (ASISA) South African – MA – Low Equity SA Real Estate: Before 2002: J255T | 2002 – current: J253T. All returns are Rand denominated.

 

Global markets | One-year asset class returns December 2015

t2

Source: Morningstar, Sanlam Investments.
Balanced: Proxy for a diversified portfolio : 65% MSCI World | 35% Barclays Global Treasury. All returns are USD denominated.

 

These graphics illustrate just how valuable diversification is. No one asset class is always the best-performer annually, and this is particularly true in the global context (locally, listed property is the outlier in the past decade… but these trends can’t – and don’t – continue forever).

It is no use lumping all your investments in a pricey general equity unit trust and hoping for the best. For one, the South African investment universe is relatively (some would say ‘very’) limited. Let me be clear: ‘diversifying’ yourself in the limited JSE investment universe is not true diversification.

Secondly, and far more importantly, as I argued last week: you’re probably significantly more exposed to South Africa than you think. You likely own at least one house here, have some form of structured retirement savings, with non-trivial limits on how much offshore asset exposure you’re ‘allowed’. There’s a pile of cash savings too, barely keeping up with CPI … if you’re lucky.

Still think you’re diversified sufficiently?

I’ve taken the Sanlam Investments ‘quilts’ and translated them into something more practical. This is the five-year performance (net of fees) of a R100 000 investment made on January 1 2011.

 

t3

Cash has effectively kept up with CPI (at the end of last year, you’re scarcely R1 000 ahead), even though most reading this column will be experiencing inflation in excess of the average. Local bonds haven’t fared too much better.

Equities have done well, especially on the back of a weakening currency. Global equities, as we all know, have shot the proverbial lights out….

But this is mostly to do with the continued depreciation of the rand.

Remove the effect of the exchange rate and, if you’d simply happened across some dollars at the start of 2011, say R100 000 worth, and invested that in global equities, you’d have marginally outperformed local bonds. This is purely theoretical, but global equities are up 44% over the past five years – an average of 8.8% a year.

The irony, of course, is that if you’d simply taken your cash offshore and done nothing with it, you’d have outperformed the JSE.

Diversification, by it’s very nature, will never give you the best performance. However, it’s likely to give you results that are superior-to-average.

Also, there is such as thing as too much diversification. There’s noteworthy risk of being too-diversified, even on the JSE, especially if this diversification comes at a hefty price (in fees and costs).

Warren Buffett may disagree, famously arguing that “Diversification is a protection against ignorance”, but the average investor he is not.

 

Hilton Tarrant works at immedia.

Source: MoneyWeb