Tony Morgan introduces the fundaments of portfolio diversification and why it depends on your investment strategy

Diversification is a very hard subject to cover in quick time.

Go to a financial advisor and they’ll go through their structured process of investing your monies, with the general steps being quasi scientifically determined as follows,

1. Define the Investment Strategy (short, long term, capital preservation or growth, risk profile),
2. Determine your asset allocation,
3. which proceeds to the individual investment Decisions to be made.

From then on the endless monitoring, meetings to discuss your investments and guiding you as required. And taking their fee at the end of the day.

Leaning upon a paid advisor will be a wise decision, where expertise is justified in your opinion. Because there is so much regulation around financial advice, the advisor industry likes clients to fill out many forms to quantify the above three steps and thus saving their bottoms, especially in times of difficulty, i.e. when markets are down or a specific investment flops. At these stress points advisors, will go back to those documents to test your metal (they will refer to those lovely documents you signed off) and as levers to keep you on track, not to capitulate. Lovely.

But as we know you can do all this yourself and be as formal or informal as you like.  Just like our four Amigos from last week. Make up your own mind.

Investment Strategy

This will generally be dictated wherever your starting point is. Let’s quickly recap our Amigos.

Stud, 26, good income, but no free cash flow for investments yet (but getting close to investing…that’s the word from the horse’s mouth). Theoretically he should target 100% growth investments, i.e. some mix of shares.

Shepherd, 35, with an increasingly good salary, great free cash flow to apply to investments, portfolio already $250,000, almost 100% international shares including ETFs. His portfolio is high growth (thus risk is everywhere, a volatile portfolio in real time) orientated with no foreseen requirement for the funds within five to ten years.

Silver Fox, 45 (one year younger than my initial guess, my apologies SF), has $500,000 plus invested 100% in international equities, split about 75% core portfolio and 25% trading portfolio. He has a very good income stream thus has no immediate cash requirements. His growing girls are more than well fed!

And yours truly, in his 56th year is ably hobbling around planting natives to save the world (ha ha). On the investment front line, he is still a willing capital growth oriented animal, but biasing more and more towards income generating assets especially stocks that can pay respectable dividends. The investment portfolio is mainly NZ stocks, however 75% is in one particular stock (non-dividend paying at this stage), the other 25% in mostly dividend paying stocks.  A good wallop of cash is held outside the portfolio to provide for living expenses (how long that lasts is a good question, given the faster rising living costs recently.

Asset Allocation

The key point above that we can be quite clear on, is that both the Shepherd and Silver Fox do not require an immediate income stream from their investments. They are seeking growth investments, willing to primarily target stock ideas as they see best.

Whereas our family is relying on our portfolio to provide the potential for both income and capital growth. A large cap stock like Pfizer, the most well know Covid-19 stock (had your jab?), pays 3.5% per annum, actually has paid over 330 quarterly dividends in a row!, is a good example of a potential candidate to include in the portfolio. We are long … and will talk further the reasons why (in detail) next month.

When Stud begins investing he will allocate 100% of his non-living cash requirements to equity ideas. He already favours the idea of investing in ETFs.

Most investors will allocate some funds to fixed interest and or bonds and listed real estate investments to provide some income. Those asset classes are also generally more secure and less volatile than most other asset classes especially pure-play companies, i.e. shares.

Some of you may have crypto currency. This emerging class of currency is beyond this author's scope of comprehension, thus sorry no further discussion (please bear in mind Silver has some in his trading account. He just thinks he likes the demand supply equation!?).

The Investment decisions

Here the diversification within asset classes will take place.

Theory will state that the asset allocation decision is the #1 overall precursor to long term returns.

I will not try to disagree.

However, when it comes to the actual specific investment decisions within shares in particular, returns from this class can vary dramatically from one portfolio to another depending on the picking of investments (and diversification within) and the longer-term decisions around holding, selling and buying. Very important to remember this.

So, what could we say is an optimal diversification strategy in shares?

It comes down to your willingness to be involved. The research, the understanding of the individual investment.

What ignites your willingness to invest directly?  This is where it gets interesting after we quickly examine the no-idea bias…

If you have no idea, then you will as I said above, seek advice and or use exchange traded funds (ETFs) to cover your bases, i.e. cover as much of the worlds stocks on a kind of industrialised basis. That is really what ETFs are for - low cost, efficient vehicles for Mr., Mrs., Miss, and Master Jobs who has an atheistic approach to investing, whereby the herd noise suggests virtually no one can outperform. So why try.

This is a pragmatic, but somewhat dull view on the idea of investing, but nevertheless fills the hearts of many and is a massive industry. There are more ETFs being marketed than the stock universe - enough said.

Back to the DIY team (Amigos included).

Now there are more questions to front up too.

What size company do you want to invest in? Does it matter?

What industry do you like the look of and will this help the overall risk, reward returns of your portfolio? Industry sectors are very, very broad, some categorisations being technology (hardware, software), health, food, retail, pharmaceutical, industrial, automotive, leisure, service, energy, communications, the list goes on and on.

Here is where the detail is, where the percentage allocation within your portfolio makes sense or not.

Next week we will get into the nitty gritty, examine the detail a bit further on the stock picking decision-making process (this will be a very long running theme, being open, transparent and most importantly real time to awaken your material neurons!).

I will talk about why the number seven is my favourite together with thinking about the pipeline and their roles in diversification. And of course, the Amigos will be back.

Tony Morgan has run a portfolio management business and an equity brokerage, both of which were purchased by Craig Investment Partners. He now runs a small family office that invests globally. Other articles in this series can be found here. And the profiles of all the NZX50 companies can be found here.