Analysis

The most important investment decision

eggs in one basket

Diversification is one of the most powerful risk management tools available to all investors. Many investors are well diversified in a particular area (for example, shares) yet fail to recognise the opportunities that other asset classes represent. Investors have more choices than they recognise when it comes to asset classes – old and new

Discussions around diversification often narrow in quickly to diversification within asset classes, but studies show that it is the diversification across asset classes that is the biggest single contributor to returns.

This is not an issue for professional investors. Their asset allocation parameters are incorporated in their mandate – whether they are a traditional long-only fund or a hedge fund. All a professional must do is stay true to label, respecting the asset guidelines put in place. Investors may then decide if that fund represents the best choice for them.

“Asset allocation” decisions are a key driver of investment success, yet many individual investors ignore or severely underestimate their importance. This is highly evident in Australia. Among individual investors, overexposure to property is the most common asset allocation issue. Self-Managed Super Funds are often overweight shares, and particularly Australian shares.

The right asset allocation decision is a matter for each individual. Good investment decisions must take into account differing timeframes, goals and risk appetites, among other factors. Widening the investment scope gives investors greater opportunities to increase returns while reducing risks. In the interest of better investment, here are the neglected children of Australian investment:

Cash – everyone keeps some cash, but its power as an asset class is regularly neglected. Even with cash rates at zero, there are reasons to maintain cash balances beyond the demands of liquidity. If an investor has a low risk appetite, or is concerned about the outlook for asset prices, lifting cash levels can increase the sleep well at night factor. The risk in keeping high levels of cash is underperformance.

Bonds – formerly a difficult market to access, exchanges and providers are making it easier for individuals to invest in bonds, both government and corporate. Individuals can now buy bonds through a public purchase on the ASX, acquisition from a private sector bond specialist or make an indirect investment through vehicles such as Exchange Traded Funds (ETFs).

While some focus on the available yield, many bond investors have reaped bonus capital gains over the last ten years as interest rates dropped. Concerns that interest rates could be rising have seen professional bond investors shorten the average maturity of their portfolio.

Gold– a favourite of Swiss bankers and conspiracy theorists, the yellow metal remains a popular choice among diversifying investors. Personal preferences dictate the choice between holding physical bullion or a platform traded gold exposure, or a combination of both. In the 1980s it was rumoured that Australia’s richest man stored $100,000 in gold bullion, hidden somewhere in his corporate headquarters. Investors can also buy gold ETFs, shares in gold companies or take short term exposures through trading instruments such as Contracts For Differences (CFDs).

Other commodities – exposures to platinum, crude oil, natural gas, lumber and cotton, and many other commodities are all available to individual investors. Although it often requires specialist information, investors may use CFDs and ETFs to take individual commodity positions, or invest in specially created baskets of commodities.

Volatility – yes, volatility is its own asset class. Stripping volatility from instruments such as options and convertible bonds is a specialist area, and not for most individual investors. It rates a mention because volatility has a very valuable quality – it moves in the opposite direction to shares. When shares fall, volatility generally goes up, making it a powerful hedging tool. Difficult, but worth the effort.

Cryptocurrencies – offer a binary and volatile exposure for those with steelier nerves. Many traders are focused on the possibility of a cryptocurrency becoming a global means of exchange, possibly underestimating the power of blockchain technology. Bitcoin has the leadership fore now, but the any winners in the space are likely to come from the later and more technologically advanced instruments

Non-Fungible Tokens – are a new form of digital asset. They use blockchain technology to allow unique ownership of a digital asset such as an artwork, a tweet or an essay. Creating an NFT is a way for the creator to sign and certify their work, making a unique asset. This may be the fastest growing asset class in the world today.

Optimal asset allocation generally changes overtime.  Investors with a solid, well thought out investment plan that includes asset allocation can ride out shifts in markets, and avoid reactive and panicky responses to regular market “crises”.

This article first appeared in the Australian Financial Review