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.

 

There – I said it! Negative gearing is all about losing money – it involves debt and high risk yet I’m almost certain that many readers will have never heard it described so bluntly.

 When was the last time you heard anyone point this out?  The promoters of negatively geared investment strategies (into property and/or shares for example) have much to gain from encouraging people to negatively gear so you won’t always receive the full story from parties who have a vested interest. So let’s look in detail at negative gearing: What is it? When is appropriate and what type of investors is it suitable for?

Gearing?

Gearing is a proxy term for ‘borrowing’ – it’s as simple as that.  You might sometimes see the term ‘leveraged investing’ wherein ‘leveraged’ also simply means borrowing.

Gearing, like how gears on a bicycle enable the rider to get over very steep hills, enables an investor to buy a larger investment(s) than their financial position would otherwise allow.  Similarly, like a ‘lever’ can enable the movement of large objects with much less human effort, so too does leveraged investing permit a larger investment(s) to be purchased than might otherwise be possible.

Gearing – leveraging – call it what you like but the bottom line is that involves borrowing money.

Negative?

This is where money is lost.  The negative in ‘negative gearing’ applies wherever the costs of servicing the investment such as loan interest, professional fees, investment maintenance (repairs etc.) exceed the income being generated by the investment(s).  In other words, the investor has to spend more to hold the investment than what the income received from it amounts to.

“Yes – but at least I can get a tax deduction!”

True, but as I once heard it stated quite simply: “That’s like spending a dollar to save 50 cents.”  And note that, under current Australian tax law, a deduction is permissible wherever the asset is Australian based and produces taxable income.  The deduction applies only to the amount of costs (interest etc.) which exceeds the income received from the investment.

So why would anyone ever negatively gear an investment(s)?

This is the key point – such an investment strategy only makes financial sense if there is a likelihood that the value of the investment(s) will increase over time.  And it is time which is a key determinant in whether or not a profit can actually be made from the strategy.

While waiting for the value of the investment(s) to increase, under a negatively geared investment strategy, an investor is losing money on the cash flow – i.e. the costs exceed the income less any tax deduction which might be available.  As such, the longer it takes for an investment to increase in value the higher the accumulating cash flow losses (negative).

So if asset values are being pushed higher quickly during say high economic growth or high inflation periods, the more quickly a negatively geared investment strategy becomes profitable – capital growth exceeds the losses being made on the cash flow.

Who does it suit and when is it best to do it?

Primarily negative gearing is most suitable for investors in the highest income tax bracket. This is because the tax deduction they can receive is at a higher level than someone on the lowest tax bracket, for example.  This just means they have less out of pocket costs in meeting the expenses of the strategy.

Periods of high economic growth and/or high inflation are generally more beneficial for negatively geared strategies simply because asset values increase more quickly at such times.

Note however that, for around twenty years, Australia has had quite low inflation and economic growth, despite the resources boom of recent years, is currently modest.

What’s the risk?

There’s more than one risk but suffice to say the list of risks includes: loan interest rate rises – loss of employment income required to cover the ‘out of pocket’ costs (investment costs – investment income + tax deduction = out of pocket costs) – prolonged injury or sickness of the investor (out of pocket costs) – slow investment value growth – declines in investment values – slow economic growth – low inflation – a future government might cancel the tax benefits …

Neutral? Positive?

Investors don’t have to gear negatively – it is possible in some situations to have a neutral gearing position or even a positively geared investment(s) and I’ll explain these strategies in my next blog.

Ray

 

       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.