Time for the diversification conversation

Patrick Broughton
28 Jun 2018

Time for the diversification conversation

A regular topic of discussion at Dixon Advisory’s Investment Committee meetings is diversification. We often ask the question: are the assets and risks we are considering linked in ways we need to be aware of?

Simply put, diversification is all about not putting all your eggs in one basket.

 

At one of our past meetings, we considered a (not too) hypothetical example of this “basket”: an investor who has a high weighting to Australian shares, a portfolio of bank hybrids, and a residential investment property held outside their self managed super fund.

On the surface, Megan's portfolio appears to be diversified with exposure to different types of assets – shares, property and hybrids.

Low interest rates have driven Australian share prices up, encouraged investment in bank hybrid securities as the cash rate is so low, and fuelled a sizeable increase in property prices. With careful planning and consideration for her strategy, these factors have resulted in good returns for Megan's portfolio.

However, it is interesting to consider what might happen to our investor were the property market to falter, perhaps as a result of increasing unemployment.

The obvious direct effect is that the value of the investor’s investment property may fall in line with the broader property market.

Another possible effect is that the increase in unemployment may increase the banks’ bad debt rates as borrowers can’t repay their mortgages. This would impact bank profits and its ability to pay dividends. A reduced ability to pay dividends could also affect the price of its hybrid securities.

A representative portfolio of Australian stocks (say the ASX 200 Index) currently has a high weighting to the financial sector, especially to banks, with financials representing around one third of the index. Accordingly, any impact on the bank’s profitability would likely negatively affect the value of the portfolio.

 

All these factors could simultaneously impact the investor’s net worth: a fall in property prices, a fall in the value of bank shares and a fall in the price of bank hybrids.

The Reserve Bank of Australia and the bank regulators are clearly uneasy about the potential for any significant weakness in house prices and systemic risk from the large exposure the banking sector has to residential property (according to the 2015 Murray report, 66 per cent of the Big 4’s assets are residential mortgages).

Are these scenarios likely? They are at least conceivable.

Would my portfolio react like that? Possibly.

Could I/we cope if it did? Perhaps.

If the answer is “no” then you may need to consider where you might need to change and diversify your portfolio accordingly to properly adjust for risk.

 

Glossary of terms:

Bank hybrid securities: investment securities issued by banks which are generally listed on the Australian Securities Exchange (ASX) with five-letter codes, e.g. XYZPC. They are referred to as hybrids because they have features of both debt instruments (fixed income) and equity (shares). On the debt side, buying a bank hybrid security is like lending money to the bank. Lending money to any institution carries risk and these hybrid securities are not covered by the Australian Government bank deposit guarantee like term deposits and savings accounts are, so they therefore pay higher rates of interest to compensate for these risks. On the equity side, because they are listed on the ASX they are subject to price fluctuations, much like a share. However, the terms will vary and can be complex for the different bank hybrid securities, so it is important to assess them individually.

Diversification: this is a risk management strategy that aims to spread investments among different types of investments and asset classes. As not all asset categories, industries, or stock prices tend to move together in unison, this can help minimise concentration risk and the overall risk of loss to a portfolio.

Index: are typically used as benchmarks and broad measures of performance of an asset class (say shares) or subset of that asset class. In Australia, the S&P/ASX 200 Index is recognised as the investable benchmark for the equity market (share market), and is composed of the 200 largest ASX listed stocks by market capitalisation. The S&P/ASX 200 Financials subset, composed of the largest banks and financial companies, accounts for 33.5 per cent of the index.

Market capitalisation: the value of a company that is traded on the share market, calculated by multiplying the total number of shares by the present share price.

Portfolio weighting: this is the percentage composition of a particular holding in an investment portfolio. Portfolio weights can be calculated in different ways, but the most basic method is dividing the dollar value of a security by the total dollar value of the portfolio. The greater the weighting of a particular asset in your portfolio, the greater the effect of a price movement of that asset on your overall portfolio.

Systemic risk: the risk of collapse of an entire financial system or financial market, as opposed to risk that’s confined to a specific company or entity. In banking, it’s the risk posed by the failure of one institution (due to bad loans, a run on deposits, internal issues, capital adequacy, etc) on the entire financial system.

 

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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