Investment Success Equals Diversification

Investment Success Equals Diversification

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The biggest mistake an investor can make is to ignore those investment principles that we’ve heard so often they become passé, especially during a bull market when it seems even the company driver is able to make good money.

However, once the correction comes, how often do we hear that now is the time to go “back to basics”? Well, the world’s worst kept secret is that the people who make money from investing never forget the basics – like diversifying their investment returns.

Broaden your horizons

One of the fundamental principles of both business and life is to have income from several different sources, so you’re not tied to the idiosyncrasies of any one source. Well, the same applies to investment: diversify.

Business strategist and author Donald Sull, speaking to GIBS MBA students at the end of March this year, listed the single biggest differentiator between success and failure as diversification, and that applies as much to business as investment. The reason is that financial crises and market collapses are happening more often, and the cycle will continue to accelerate. His message: get used to it and realise these market corrections are the primary means of making money – not losing it.

His latest book The Upside of Turbulence demonstrates that there have been four serious global financial crises in the past 30 years, compared to four in the previous 300 years – but that the latest series of crises coincided with a period of unprecedented increase in global per capita GDP. It is a classic J-curve graph. So turbulence, volatility, interesting times – call it what you will – should be your best friend, not your worst enemy.

Beware of greed

It has always been the mantra of any financial adviser that you must diversify; do not have all your eggs in one basket; you can improve your risk adjusted return by investing in uncorrelated assets.

Despite the constant repetition of the mantra, ordinary investors seem blind to the advice. The underlying reason is usually greed. However, what people fail to realise is that no financial adviser is suggesting investors should accept lower returns in exchange for reducing risk through diversification, only that they measure those returns (which should in fact be higher, if it’s a prudent strategy) over a longer time period.

Raymond Berelowitz, CEO of SYmmETRY (Old Mutual’s multimanager arm) says people are not earning the returns they see in the media. Because investors have increasingly short time horizons they are not making the actual returns of the funds they’re in, after switching fees and other costs. Worse, through timing errors they often lock in massive losses.

One major reason for diversification is the argument proposed by Warren Buffet that the biggest contributor to long-term returns is not the rate of annual return but the occasional negative returns during market corrections – those cannot be made up. Even if your fund returned 60% this past year, it would not make up the 40% lost the previous year.

Long-term planning

Tommy Ferreira, a Citadel wealth planner, says in the short-term an investor will sacrifice some of the equity return by not being 100% invested in equities – but a portfolio should be looked at over 10 years, not three months.

“Although the 2008 market correction was as close to a synchronised (all asset classes) recession as we’ve seen since the Depression, the reality is that cash, bonds and fixed interest investments outperformed equities. You are only going to get high equity returns half the time – for the rest you need to diversify,” says Ferreira.

The theory of diversification is that each asset class reacts differently to stimuli, especially the interest rate cycle. Investors tend to look at the periodic phenomenal returns earned on the JSE, but Ferreira says the reality is that the JSE has returned on average 7,5% real (above inflation) a year since 1996. Within that, there are periods of over and under-performance.

Lara Warburton, MD of Imara Asset Management, says the past market correction was the nearest example one can find to where diversification did not help, because all asset classes were affected. But they certainly differed in their speed of recovery from the bottom. Corporate bonds recovered very rapidly, as have domestic equities. Anyone who remained invested would not have lost hugely.

Trust is vital

“The single biggest danger is panic. For those people who didn’t panic, the recovery was quick, but my experience is that people are their own worst enemies,” Warburton says.

Why this happens, she says, is that individuals do not trust their financial adviser. “The biggest impediment to advising a high net worth individual is that he is often dealing with several financial advisers, none of whom has a view on his total financial position. Often, the individual thinks this is diversification – it is not. What it is, is a group of advisers all doing more or less the same thing as each other, as they are functioning in a fog.”

Her advice: find one financial adviser you can trust and entrust all your capital to that organisation so they have a holistic view.

Eamonn Ryan
Before becoming a financial writer and freelance journalist in 1997, Eamonn Ryan was a legal adviser, company secretary and alternate director at listed company Cashbuild Limited from 1988 to 1997. Since becoming a financial writer, he has focused on the business and financial sectors, as well as personal finance, writing for Finweek, The Star Business Report, Sunday Times Business Times, Business Day, Mail & Guardian, Entrepreneur, Corporate Research Foundation (which brings out a series of books each year ranking SA’s best employers and best managers), as well as a host of once-off and annual publications such as ‘Enterprising Women’ and ‘Portfolio of Black Business’. He also writes media releases, inhouse magazines and sustainability or annual financial reports for various South African corporates and financial services groups, including the Ernst & Young annual M&A book.