Andrew Gawith: Best to expect the unexpected

There's more to achieving effective diversification in an investor's portfolio than simply meeting the appropriate appetite for return and tolerance of volatility at the asset class level.

Equally important is the need to ensure that within each asset class the exposure to specific companies and/or industries is sufficiently diversified.

In last week's column I touched on how the risk (or volatility) in expected returns for shares and fixed interest is poorly understood by many investors even though it is the major factor influencing their returns. Investors may also not appreciate the extent to which a large holding in their portfolio to a particular share or fixed interest security (or a particular grouping of shares or fixed interest securities) may similarly have an impact on the amount they get in their pocket when they come to retire.

Investors should always make sure that there's a good spread of securities within each asset class so that in the event a company gets wiped out, their portfolio escapes with a bit of a bruising rather than a total thumping. The finance company debacle is a good example of how investors have seen their life savings evaporate because they've ignored the risk specific to the individual asset class.

However, it's not only finance companies that investors need to be wary of. There is always a danger that even the most "blue-chip" of companies can come unstuck.

Take the unfortunate and distressing events surrounding BP.

The company had all the qualities an investor might usually associate with a blue-chip company. A strong balance sheet, good ratings from the credit agencies, solid cash flows, a healthy dividend to keep shareholders happy and opportunities to increase their existing resource base. Furthermore, BP had begun to focus on moving its investments away from lower return assets and was specifically targeting increasing the profitability in its downstream activities. With a strong focus on capital discipline and cost control the company's first quarter 2010 profits came in at a massive US$5.6 billion, well in excess of what the market pundits had expected. Investors were on to a sure winner. Right?

This benign backdrop was of course overshadowed by the explosion at the Deepwater Horizon rig while an exploration well was being drilled. As a result of the subsequent oil spill the stock is now down almost 50 per cent from a peak in April.

Costs for the clean-up have spiralled and investors have become more concerned about litigation and the punitive and compensatory damages that seem certain to follow in its wake. Ironically, deepwater drilling was regarded as one of BP's real areas of expertise. The recent debacle with BP shows perceived "quality" offers no defence against disaster.

No matter how confident you are about a company's future prospects and the state of its financial affairs there is always the possibility that an investor could be plain wrong or simply side-swiped by an event out of the blue.

These events occur more often than many investors imagine. Sundance Resources was left reeling last week after members of the board were killed in a plane crash.

The only effective method to reduce the impact of blow-ups in investment portfolio is to be properly diversified in the first place.

It doesn't eliminate risk but it certainly helps keep it under control. Standard portfolio theory suggests that you need somewhere between 20 to 30 shares to achieve sufficient diversification.

There are some qualifications to this. It doesn't mean buying any old collection of shares.

Consideration needs to be given to achieving an appropriate spread amongst different industries and sectors and even countries. Neither does it mean backing one company to the tune of 90 per cent of the portfolio and spreading the other 29 shares in the portfolio amongst the remaining 10 per cent.

It's a sensible approach to always think about the impact on an investment portfolio of a particular security halving in value or in the worst case, having no value at all.

Principles of diversification hold true to any asset class and are as relevant to fixed interest as they are to shares.

Just ask the investors holding 20 debentures in 20 different New Zealand finance companies.

Unless there is some control over the level of exposure at the individual security or industry level within an investor's portfolio, a single security can blow a large enough hole in a portfolio that it is almost impossible to climb out.

Investors should always be wary of portfolios heavily backing the sure bet.

Andrew Gawith is a director of Gareth Morgan Investments.