Why IS It Imporatant To Diversify Investments?

May 2 - 3, 2009. To diversify investments basically means to divide your financial eggs between different baskets.

We are usually advised to diversify our investments across “asset classes” rather than baskets, to reduce our risk of losing money. What does this mean, and what do the different asset classes typically consist of?

An asset class is a group of investments that display similar characteristics. There are four main traditional asset classes recognised to diversify investments: shares, bonds, property and cash. Most investment professionals would argue that there is also a fifth asset class: alternative investments, such as hedge funds.

Asset Classes to Diversify Investments

A share investment is generally well understood. It is an investment in a public or private company. A shareholder receives a proportionate share of the profits that the company earns over time, usually paid out in the form of dividends. The share price is an indication of the expected future profits (and dividends) and fluctuates depending on the perceived future success of the company. Although dividends, and growth in dividends, are an important part of the overall returns that shares provide, it is usually the long-term increase in the share price that results in growth in our financial wealth.

Property is a popular asset class, probably because of its “bricks and mortar” tangibility. It is similar to a share investment, in that it produces a revenue stream (rental income) and the potential for longer-term capital growth. The most popular type of property investment is residential, although there are commercial and industrial opportunities as well. In our experience, the average investor underestimates the time and costs that accompany a residential property investment. Direct property is not a passive investment. There is, however, an advantage in being able to use tax-deductible debt to invest in this asset class.

A bond is essentially a loan from the investor to a government, institution or company. The borrower promises to pay the lender interest and repay the original loan amount at a future date. The interest rate is dependent on the credit worthiness of the borrower. Government bonds generally offer the lowest interest rate as they are perceived to be the safest type of investment, as a government could always print more money. However, an investor would require a higher interest rate on a loan to a struggling company to compensate for the risk of default. The price of a bond investment can fluctuate with changes in general interest rates. It is therefore important to remember that the market value of this asset class can also produce negative capital returns in the short term.

Cash is perhaps the most popular asset class, consisting of money market investments, fixed deposits and bank accounts, amongst others. The temptation to invest in cash is high, as there is very little likelihood of capital loss. However, there are dangers in investing too much money in this asset class. After taking into account tax on the interest returns, there is the possibility that money invested in this asset class will be eroded by inflation over time.

Alternative investments have received a lot of press lately. Alternative investments aim to produce positive investment returns under all market conditions. The recent global economic crisis has put pressure on this objective. There are many types of alternative investment strategies, but most of them use some form of “short selling” to try and make positive returns in a declining asset price environment. This involves an agreement to sell an un-owned asset at a future date at a certain price. If the price of the asset falls in the interim, then it can be bought cheaply before the date of sale and a profit will arise. Complexity and credit risk are the main concerns with this type of investment. Hedge funds are not currently regulated in South Africa and can employ leverage, so be careful.

Points to Note To Diversify Investments Successfully

When constructing an investment portfolio appropriate to your circumstances, remember that each asset class has different risk and return characteristics. While asset class characteristics are similar in South Africa and overseas, there are subtle differences. It is important to understand how the returns are correlated to each other under different market conditions. The tax treatment of returns should also be considered.

Constructing a portfolio to diversify investments across different asset classes is complicated and is more effective when implemented as part of a holistic financial plan. This ensures that the portfolio is correctly structured to achieve your lifetime financial goals. If you are unsure of your own skills to go it alone, then you may wish to engage an independent, fee-based Certified Financial Planner (CFP) who is focused on your best interests and can provide impartial advice. If you do not know a CFP, visit the website of the Financial Planning Institute on www.fpi.co.za to select one.

Netto-Jonker, CFP, is founder of Netto Financial Services and was financial planner of the year in 2001. Her business partner Ian Beere, CA(SA) CFP was the financial planner of the year in 2007.