This week we are publishing the second excerpt from a small book Mary Holm has written for the Reserve Bank called Upside, downside: A guide to risk for savers and investors. It will be given free to the public in September. This column will tell you how to get a copy then. Today we look at examples of risky investor behaviour. The normal Q&A column will resume next week.
Investing in too few different types of assets
Some people aren't too concerned when the value of their long-term savings drops considerably. They expect it to rise again in due course.
For many people, though, a drop in value is alarming. Worry in itself is not good, and it's even worse if it leads you into bailing out of investments when their price is low. Buying high and selling low is a sure-fire way of losing money.
You can considerably reduce the volatility of your total investments by spreading your money across different types of assets, such as shares, property, bonds, other fixed-interest investments, cash, and perhaps also forestry, collectibles, gold and so on.
There will be times - when one type of investment is doing particularly well - when this strategy seems unimpressive. Surely you're better off concentrating on winners? The trouble is, winners don't necessarily stay winners. Looking ahead, there's no way of knowing which type of investment will perform best.
If you hold a range of investments, when one type is doing badly, there's a good chance another will be doing well, so the value of your whole portfolio of investments doesn't fall, or at least doesn't fall as far.
An easy way to spread your investments is to invest in a balanced fund that, in turn, holds a variety of investments. Some of these funds, however, charge quite high fees, so you may be better off to do it on your own.
If you own your own home, how does that fit into the picture?
Some people reckon that home ownership gives them enough exposure to property, and put all their savings in bonds, shares and perhaps other areas.
Others own their own home and also invest largely or solely in rental property, giving them poor diversity. They may say that they don't regard their home as an investment, and in some ways that's fair enough. The fact remains, though, that house prices sometimes fall - as we've seen in the past few years.
If a sustained price fall happened here, people with all their money in houses would be hit particularly hard, especially if they are highly geared.
Most KiwiSaver funds hold a mix of assets, such as cash, bonds, shares and perhaps property, but the proportions vary, as follows:
* Conservative, cash or lower risk funds hold mostly cash and bonds.
* Balanced funds hold a balanced mixture of higher and lower risk assets.
* Growth, aggressive or higher risk funds hold mostly shares and property.
Failing to diversify within each type of asset
Some economists claim there's no such thing as a free lunch. You can't, for instance, get a high return with low risk. Others disagree. There is one free lunch, they say. By diversifying across lots of shares, lots of properties, lots of bonds or whatever, you can reduce the total risk of all your investments without reducing your expected return.
Let's say, for example, that the annual returns we might expect on a single share range from minus 40 per cent to plus 60 per cent, with an average of 10 per cent. On a portfolio of 20 shares, we might expect the same 10 per cent average return. But the range would be narrower - perhaps minus 20 per cent to plus 40 per cent - because when some shares do badly, others do well.
Market crashes do occasionally happen, when practically all prices drop. But generally, while a single bond or share can become worthless, and a single property can lose much of its value, it's much less likely that a whole lot of them will do badly at once.
Every big institutional investor always diversifies its holdings. You're silly if you don't take advantage of it.
You can gain good diversification through managed funds specialising in bonds, property or shares. You also benefit from the savings gained from the managers' large scale operations. For example, a fund manager will pay much lower brokerage per share than you would pay if you bought individually. But, as noted earlier, you do have to pay fees, which can partly offset the advantages.
If you're investing in what are called "investment grade" bonds, the bond issuers are not very likely to default. It's still possible, though, so it's a good idea to invest in several different companies.
And if you're investing in higher-risk fixed-interest instruments, where default is more likely, it's particularly important to spread your money around - although even that didn't save some finance company investors. It's best to stick with high-quality fixed-interest.
In direct investment in property, it's hard to diversify across many properties unless you have lots of money or are willing to take on the risks of gearing heavily to buy several properties - and can find a lender who will let you do that.
If you insist on direct investment and you can afford only one investment property, keep in mind the after:
* It's not a great idea to buy a residential rental property near your home. Sure, that means you can keep a close eye on it. But if house values fall across the neighbourhood - and that can happen - you lose on both properties. Lower your risk by purchasing a property some distance from your home, and perhaps in a different type of neighbourhood, such as inner city.
* Along the same lines, it's rather risky to own more than one property in the same small town, especially if the town is dependent on one or a few industries. If there's trouble in a local industry, all property values are likely to fall - and you might even lose your job as well.
* It's also better if you buy a different type of structure, such as a unit or apartment. The house and apartment markets are somewhat different.
* You can get better diversification still if you invest in a commercial property, such as a shop, office building or factory. Their markets differ even more from the housing market - although all property markets are affected to some extent by common factors such as interest rates.
Best of all, however, is investment in a broad range of property types in different regions. For many, the only way to do this is via a property fund or shares in a company that invests in many properties.
Many New Zealand shareholders own shares in just one or a few companies. That's not clever. Holding just two shares gives you considerably more diversification than one. Three is better, and 10 is better still. Some experts say that to get the full benefit from diversification you need to hold 20, or even 50, different shares.
The easy way to do this is via a share fund or several funds. If you prefer direct share investment - which tends to be cheaper - make sure you spread your holdings across different industries and company sizes.
Concentrating on just one industry - as some investors did during the tech stock boom of the late 1990s - is highly risky. Many tech stock investors saw the value of their portfolio reduced to a fraction of what it had been before the inevitable bust came.
People who invest in a wide range of industries tend to have a much less bumpy ride.
Almost all KiwiSaver funds hold a wide range of investments in the asset types in which they invest. For example, a predominantly bond fund holds many different bonds, and a predominantly share fund holds many different shares. Your provider should be able to give you information on their range of investments.
With all types of assets, you can boost your diversification considerably by holding international investments as well as New Zealand ones. It's not uncommon for international investments to be rising while local ones are falling, or vice versa.
The easy way to invest offshore is via managed funds. And it's common for even small investors to hold units in an international share fund. As it happens, international shares have had a really up and down ride in recent years, growing extremely fast in the late 1990s, dropping an unusually long way in 2000 to early 2003, growing again since then, only to plunge in the global financial crisis and recover somewhat since.
Over the long term, though, average returns on international shares have been high. And you can invest in many industries that are under-represented on the New Zealand sharemarket.
Because the New Zealand and world sharemarkets sometimes move quite differently, as our graph shows, you can broaden your share diversification considerably by including an international share fund in your portfolio.
Similarly, you can invest in international bond or property funds.
Mary Holm is a freelance journalist, part-time university lecturer, member of the Financial Markets Authority board, director of the Banking Ombudsman Scheme, seminar presenter and bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.