What you choose today determines how much choice you have later in life.

Many NZ’s automatically think ‘product’ when considering or discussing investment. Recent examples include power company shares, KiwiSaver, Auckland and Christchurch residential property and for the less risk averse early adopters and online investors, peer to peer lending. Also, the NZ desire for self employment and the entrepreneurial attitude explains a lot about our DIY approach.

Historically, residential property and bank term deposits have prevailed, yet our share market has maintained consistent double digit returns (on average) certainly in my 40 years of involvement in the finance sector. New Zealanders have $745 billion invested in residential property, $137 billion in bank and non-bank deposits and only $28 billion in NZ listed shares.

The focus of today’s commentary however is diversification. How to reduce volatility within portfolio investment strategies, and how to reduce risk in general through common sense, calculation of the odds and reducing  emotional or reactive decision making.

Misunderstanding reigns when investors confuse ‘outperformance’ and misinterpret this as having an investment goal. It is not. Performance, outperformance or focusing on investment returns are not investment goals. Retiring at age 60 with no debt and an income of 100K (which you can’t outlive) is an investment goal. How you created this position (at age 60) was through having an investment strategy at a much younger age. In the previous two essays on this investment subject, I highlighted the need for principles and practices from which to build an investment foundation. Diversification is a fundamental practice and one which is ignored most when euphoria prevails and euphoria is addictive. There’s nothing like the whiff of instant gain to befuddle the brain whether gambling or investing in business. But the best entrepreneurs measure and manage risk.  As do successful gamblers and investors.

Within a managed fund such as KiwiSaver, ‘diversification’ means numerous securities exist in each asset class. The proportion of any particular asset i.e. shares, property, fixed income (bonds) cash – is made up of lots of different securities from different countries and different sectors. For example a NZ portfolio of shares would not solely contain energy shares such as – Contact, Mighty River Power and Meridian.

A properly diversified portfolio would contain a range of shares from different sectors (industry, finance, energy, consumer, primary industry, IT, property, health) and different countries. As I mentioned last week, NZ’s share market capitalisation is tiny compared to countries of similar population.

Country             Population         Market Capitalisation

NZ                        4.58m                    US 74 B

Singapore          5.47m                    US 753 B

Norway                5.17m                    US 219 B

Ireland                 4.61m                    US 143 B

At the end of 2014 there were 44,516 companies listed on the World Federation of Exchanges. The US and Japan – one and two. From a diversification perspective therefore owning ones entire retirement investments in NZ companies is a greater risk than spreading the investments (in all asset classes) internationally. Diversification reduces both risk and volatility, and reduced volatility inevitably leads to higher returns for the long term accumulator and investor. What happened in NZ in 1987 and 2000 when many NZ’s lost their shirts was a result of poor diversification, euphoria and inept financial planning. The wrong goal prevailed.

When proper financial planning is initiated and managed

a) critical goals are determined

b) strategies are designed to achieve them and protect them (the plan)

c) a risk/return analysis is created (what risk and therefore type of securities, taxation decisions, asset allocation, existing resources, new money, insurances),  

d) a portfolio created (arrangement of products),

e) a review process arranged to ensure a rebalancing to prearranged percentages.

A financial planning procedure consists of three critical strategies, not one. An investment strategy on its own is doomed to fail, usually because the goal was not accompanied by an expansive list of what else is needed to enjoy a comfortable lifestyle over 30 years of growing a business or growing an investment. Or the ‘what ifs’ which may and do occur with regard to health, accidents, business failures, marriage failures, market adjustments (GFC), political and environmental change. Markets recover (the average is 40 months from record high to low, back up to new record high) and in my lifetime there have been around 14 major occurrences of this. But the gains have been permanent and the losses (in a well diversified portfolio) temporary. But death, permanent disablement, bankruptcy, divorce is often the end game for families and businesses – the diversification and management of strategies to manage these eventualities are as equally important as the lifestyle goals one would like to achieve pre and post retirement.