If someone were to ask me to name the three most important ways to reduce investment risk, I could only respond with:

Diversification – Diversification – Diversification! 

It really is that straightforward yet it would be very easy for someone to think that ‘diversification’ simply meant ‘spreading your eggs over more than one basket’ – putting money into more than one investment.  But it’s not that simple because investment diversification needs to be applied at several levels in order to properly reduce risk.

The starting point with a discussion on investment risk management has to be an acknowledgement that all investments are accompanied by risk. It’s impossible to make any investment without taking on some measure of risk.

As if to graphically illustrate this further, the Global Financial Crisis and its aftermath put paid to the often-quoted belief that government bonds are safe.  For several years now the world has been grappling with the possibility of several European governments defaulting on their loan (bond) repayments.

Whether or not any government bond is secure is ultimately dependent upon the ability of the borrower (in this case, a government) to repay the loan.  Note here that government bonds exist because governments need to borrow money from the private sector to fund their operations – be they short or long-term requirements.

Notebook PC with charts, graphs in background

So, if we begin to look at investment risk management from the premise that all investments involve a degree of risk the task becomes somewhat more complex.

Proper investment diversification is a three-step process over sectors, legislation and individual investments:

1.    Sector Diversification

The primary investment sectors are:

  • Cash
  • Fixed Interest
  • Shares
    • Australian
    • International
  • Property
    • Direct
    • Listed and/or managed

Yes – there are so-called ‘alternate’ investments that some, more speculative, investors will commit money to however that’s for another discussion.

At all times, risk exists in each and every of these sectors and managing those risks is achieved by avoiding inappropriate weightings (over or under weight) to them.  Even a 100% cash portfolio entails risk; the risk that what is otherwise good for the economy – low interest rates – is not good for an investor who needs consistent income. While the capital might not decline in a cash account due to a ‘market downturn’, capital can and does decline when the investor needs to drawdown on the capital to meet living costs because the interest being earned is insufficient. In addition, the ‘buying power’ of cash accounts erodes over time due to inflation.

2.    Legislation Diversification

This is perhaps the area of risk most often overlooked by investors simply because it is not immediately apparent to them.  In Australia, very many people have their non-housing wealth invested entirely in superannuation, save for everyday cash and deposit accounts.

The quite onerous legislation within which people save for their retirement comes with a quid-pro-quo relationship between the government and the superannuation member. In return for, generally speaking, quite generous taxation benefits both before and after retirement, superannuation members lose access to their capital throughout most of their working life. This is because governments of the day have increasingly looked for superannuation to be used only to assist funding retirement.

Within this ‘give and take’ type setting is an ever-present risk that a government might at some future point in time, look to make superannuation only accessible as an income stream (a pension) in retirement. Such a decision would see the traditional ‘lump sum’, which many Australians look forward to, placed be beyond reach.

While the political will to make such a change appears to be absent in current times, it is entirely sensible for Australians, particularly younger Australians, to plan to build an alternate ‘lump sum’ of capital outside superannuation. Such planning quarantines the ‘alternate’ lump sum from any future changes to superannuation. Granted it might not be as tax efficient for many investors (to accumulate capital outside superannuation) however, as per my ‘Golden Rule’ No. 1, tax minimisation should never be the primary reason for making an investment(s)

3.    Investment Diversification

This is the final step and, ironically, it is where some investors begin in attempting to diversify their capital.  Over many years, thousands of academic papers have attempted to quantify what is the most appropriate methodology to diversify portfolios. However, it’s arguable that none can claim to be the definitive approach.  That said one issue upon which there is much consistency of opinion is that getting the asset allocation (shares, fixed interest, property) correct will have the largest contribution to the final return.  And this is the irony – investors who start to diversify here (and not focus on asset allocation) – are heightening their portfolio risk and increasing the chances of under-performing.

That said, here are some key guidelines to be mindful of when looking to spread capital over different investments:

Direct Shares

Managed (mutual) Funds

Don’t rely on just one sector of the sharemarket – sectors have their

own cycles.

 

Does the fund have a minimum 5 year track record? If yes – what is the track record?

If no, does the funds management company demonstrate acceptable performance in similar funds under its management?

 

 

 

What is the market capitalisation of the company? How does that compare to its peers?

 

Do you understand the fund’s strategy and objectives? What are they trying to achieve with it and over what timeframe?

 

What is the company’s share of its market?

 

What about the people managing the fund? What is their experience and success (or lack thereof)?

Does the company pay a competitive dividend and what does the dividend payment history tell you?

 

Do you know what the entry/exit/ongoing fees are?

 

Are the fund fees reasonable compared to peers?

What is the outlook for the sector?

 

Limit a maximum 10% of capital to any individual fund.

What about governance? How well run is the business? What about the reputation of the board of directors and CEO?

 

 

Limit total exposure to any single investment institution to 25% of capital

Successful investment strategies recognise that nothing is certain and that risk abounds in every investment made.  Such strategies are, initially, based on a detailed understanding of the state of the domestic and international economies which finally results in a well diversified portfolio of investments.

And because the economies and markets do not stand still, portfolios need careful review and maintenance.

                         IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances. Readers should seek professional advice for their own situation.

 

While we live in world seemingly full of unrelenting change, there are some things that will never change in the financial world.  For a very long time, I have maintained a set of ‘Golden Rules’ that are always relevant and good for investors to keep handy when contemplating making investments.

So let’s get started with a Golden Rule that deals with tax benefits.

1.    Tax should never be the primary reason for making an investment.

Why? (people always ask)  It’s quite simple really – taxation law is subject to change so the overriding question you should ask yourself – before investing – is:

If the government were to cancel the tax benefits associated with this investment, would I still be happy to put my money into it?

If the response is ‘No’ then that – in isolation – should be sufficient to deter you from putting your money into the investment.

 

The Australian investment landscape is littered with the carcasses of investments that were marketed to investors on the basis of tax benefits which were, at times, questionable to say the least. As I write, the collapses of more than twenty years of professional practice come flooding back.  Over the years I’ve witnessed, from the sidelines, collapses of investment schemes which involved:

  • Pine trees
  • Jojoba beans
  • Cray fish farms
  • Wild flower plantations
  • Tea tree plantations
  • Ostrich breeding
  • Oak trees
  • Cattle breeding
  • Film production

Rest assured there are more failures than recorded above.  All the schemes above were variations of a theme – investors borrowed all or part of their investment and hoped for that the forecast capital and income returns came true. In many cases it was little more than the proverbial ‘wing and a prayer’ due to the fundamental flaws in the investment structures.  Some such schemes claimed that for every $1 invested a tax deduction of $5 could be claimed.

Consider this excerpt from a 2006 report by the Australian Taxation Office:

The Senate Economics References Committee found support for the view that “the growth of a highly competitive entrepreneurial promoter market … has been the most significant driver of the growth in aggressive tax planning.”

This finding built on the Committee’s previous reports. In its Interim Report it concluded:
“ it is the view of the Committee that a large number of these schemes appeared to be designed specifically to defraud the tax system and to use ordinary taxpayers in that process. Not only have they left many taxpayers with large tax bills, but many of these schemes have ceased to exist. The Committee is of the view that few schemes represented ‘a good investment’ in the ordinary meaning of the term, and that without the ‘tax deductibility’ factor, very few would have got off the ground.”

I recall explaining to students in an adult learning program which I taught that: “If the tax office ever disallows the tax deductions (on these exotic investment schemes) people will march in the street!”  And so I was not surprised to see that in Sydney, Melbourne, Perth and Canberra, so-called ‘tax effective’ scheme investors marched in protest at the Australian Taxation Office’s early 2000s decision to disallow tax deductions on such schemes[1].

To make matters worse (for such investors), the decision was made with retrospective effect to 1992.

What appealed to such investors was, in effect, a view of getting something for nothing; the so-called ‘free-ride’ that investors sometimes believe they receive when tax deductions are on offer. Of course there is no such thing as a ‘free lunch’ and many such investors were subsequently hit by the dual impact of a failed investment followed by a retrospective disallowance of tax deductions from many years previous.  For many investors, the losses amounted to hundred of thousands of dollars.

‘Tax effective schemes’ are by no means the only area where investors focused on tax deductions can be at risk. For example while I’m a great supporter of superannuation as an investment vehicle to accumulate retirement savings, it concerns me when investors have all their investment capital in superannuation. This is because – no matter how many super funds you have – superannuation is subject to constant legislative change and such change isn’t always beneficial for investors.  While it’s a very tax efficient system through which most Australians can save for retirement, there is substantial legislation risk with it.  It is sound planning to accumulate wealth in superannuation and outside of superannuation.

So the ‘Golden Rule’ is:

1.    Tax should never be the primary reason for making an investment.

Tax should only ever be a secondary consideration.  Remember: Tax laws change.

 

 



[1] The Australian Taxation Office has previously referred to the schemes as ‘abusive tax schemes’.