Don't lose benefit of diversifying

By MARY HOLM

Q. I'm following up on

last week's column

regarding diversification in a share portfolio and also the advice to buy and hold.

I hold 23 companies across a range of industries.

However, I have heard that another aspect of diversification is that one should maintain an approximately equal dollar value of each company in the portfolio.

Good performing companies, say Fletcher Building over the past few years, will from time to time significantly outperform the average.

One strategy that a friend suggested is to limit an individual company to three times the average by selling part (a third?) and reinvesting in another company.

This would mean that buy and hold does not always apply.

What is your view on this aspect of diversification?

Another aspect is that many fund managers, rather than go for equal dollar values, weight their individual shareholdings to match market capitalisation.

Which is better?

A. The first one.

You're quite right, of course, that if you start out with equal holdings in 23 shares, after a while the ones that have done well will be worth much more than the dogs.

In time, you could find your portfolio so dominated by just a few shares that whatever happens to the others has almost no effect on your total investments.

That's fine if the dominant shares continue to outperform, but what if they don't?

You've lost much of the benefit of diversification.

Your friend's suggestion not only gets you out of a dominant share, but it also means you are selling after the price has risen a lot, which can't be all bad.

Some people find it difficult to sell winners.

Note, though, that shares that do particularly well are more likely than average to do badly later. And, in any case, you're not selling the lot.

Just where you should set the upper limit of a holding is arbitrary. You don't want to be too strict. If you leap in and sell when the value of a holding is, say, twice your average, you might well see that share slide soon afterwards anyway, and you've traded unnecessarily - with the accompanying brokerage, hassle and possible tax on capital gains.

But your friend's cut-off point sounds fine to me. His or her strategy is, indeed, a good exception to the buy-and-hold rule, and I'm glad you made the point.

However, the tendency of share fund managers to hold more of the shares with large market capitalisation, which is the total value of all the shares issued, is something else again.

The local sharemarket is dominated by Telecom, whose market cap is about 18 per cent of the total market.

That means that Telecom also dominates most of the sharemarket indexes, which are weighted by each company's market cap. In turn, many index funds, which invest in the shares in an index, are also dominated by Telecom.

But what about non-index funds - or "active" funds - which select shares to buy and sell?

Their managers' performances are measured against appropriate market indexes. Apparently, many managers are scared that if their fund is not Telecom-heavy, and Telecom does well, they will underperform the index and look bad.

As a result, many active funds' investments are similar to those of index funds, but investors pay higher fees for active management. It's one reason that I prefer index funds.

Speaking of which, stock exchange subsidiary NZX Funds Management has just opened an initial public offer (IPO) of a new index fund called FONZ.

It invests in, basically, the biggest 50 New Zealand shares, but with no holding of more than 5 per cent - although some companies will creep above that between quarterly reviews.

It's not unlike your friend's strategy.

While the IPO is running, until December 3, investors can sign up for a regular savings plan, investing $1500 or more up front, plus $50 or more a month.

After FONZ is listed on the stock exchange, probably from December 15, the savings plan will no longer be available, although management may reintroduce it later. I hope so.

Apart from the lack of Telecom dominance, FONZ has some other attractive features, such as automatic reinvestment of dividends unless you request otherwise.

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Q. You might be interested in Oprah Winfrey's (and others') definition of luck, which is "Preparation meeting Opportunity", or as golfer Greg Norman said, "The harder I work the luckier I get".

A. You're obviously referring to my comment, last week, that investors who are lucky with shares often call it skill.

Sure, "luck" is often the result of hard work. As I've been saying in the column lately, though the sharemarket is different. Individual share investors' research is usually useless. If it bears fruit, that's almost always good luck - unless they were illegally insider trading.

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Q. A part of my letter, which you published recently, was edited out. I was intending to warn the dominant partner in a retired couple, who is usually a man, of the difficulties of having only one car, however financially sensible it might be. It is a rare man who would be prepared to share his one remaining symbol of independence with a wife. The method of operation which I described can only work if both partners are exceptionally tolerant, understanding and reasonable. In fact, my husband is the only man I know who fits that category!

I should hate to think that my letter could deprive a wife of her means of transport.

A. So would I - although I think you're being a bit tough on the blokes.

In your first letter, you said, "It is vitally important that both partners keep up their proficiency behind the wheel as the 80-plus driving tests approach.

"When we went out together in the car, one partner drove out and the other drove home, and this has paid dividends as one of us can no longer drive."

That's a good idea, but unfortunately it was edited out because of a shortage of space. Second time lucky!

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