Diversification v Concentration: A tortoise and hare story

160315.Diversification v Concentration

Concentrate your investments to make and lose a lot of money

The following recent Twitter exchange was the catalyst for this article:
 

 
The initial tweet above is a quote from Jim Rogers, a well known US investment commentator, who believes he can reliably pick investment winners and time investment markets, despite robust academic research suggesting such skills are both incredibly rare and difficult to identify. However, his view that if you want to make a lot of money you should avoid diversification (i.e. spreading your investments as broadly as you cost effectively can) is undoubtedly correct.

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Your emotions complicate investment decision making

Your emotions complicate investment decision making
Lifestyle asset decisions have a heavy emotional content

It’s not always clear what’s a lifestyle asset versus an investment asset. Recent discussions with a client regarding a proposed holiday house purchase raised some interesting issues not only in relation to this matter but regarding investment assets, more generally.

In this case, the client expected that the holiday house would be available for rent for most of the year, with the family using it only for a couple of weeks during peak holiday periods. Based on previous net rental income figures, the return on the property would exceed the current cost of borrowing.

The client’s reasonable view was that because of the anticipated net income, the property should be regarded as an investment asset rather than a lifestyle asset. Further, given the likely reliability of that income, he questioned whether it could be considered as an alternative to holding low yielding, high credit quality, defensive assets.

We were not comfortable with the “defensive asset” alternative idea, given that prices of holiday homes fluctuate considerably and, in poor markets, there is often little liquidity. However, a typical response to this view is that there is generally no intention to ever sell a holiday home. Often, it’s regarded as an asset for the family to enjoy and, potentially, to be passed on to the children.

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Don’t put all your investment eggs in one basket

Dont put all your investment eggs in one basket

Concentrated investments add to risk but have no expected extra return

Our previous article in our series on the Personal Financial Dashboard – a graphic format that succinctly captures the journey to, arrival at and maintenance of financial independence – examined the rationale for setting a target maximum growth asset allocation. And, as a corollary, a minimum defensive asset allocation.

This article looks more closely at an aspect of how both growth and defensive assets should be held in order to increase the chances of both becoming and remaining financially independent. It is the focus of Chart 6 of the Personal Financial Dashboard, the Diversification Ratio.

When you are relying entirely on your investment wealth to finance your desired lifestyle for an indefinite period, it’s generally not the time to take more investment risk than you need. While you may wish and require your wealth to grow, effective wealth management should largely be about ensuring that in the quest for higher returns unnecessary risk is avoided.

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The Great Dividend Yield Chase

The Great Dividend Yield ChaseHigh dividend paying shares appeal to many investors

It’s often suggested by various investment “experts” that the first requirement for a share investment is income return and then growth of capital. This implies that income return is a key driver of investment performance. Perhaps it explains why so many investors are so focused on income yield when choosing a share investment.

While we don’t know conclusively why investors have a preference for dividends over capital growth, some of the reasons we’ve heard include:
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Baby boomers’ housing experience may not repeat

Baby boomers’ housing experience may not repeat

Baby boomers still borrowing to buy property

Over the six years to 2009-10 [1], baby boomers (those born between 1945 and 1964) continued to pour money into both owner occupied housing and other property. And they were happy to take on additional debt to do so.

The table below shows the change between 2003-04 and 2009-10 in the percentage of households, by age of reference person, where the homeowner has a mortgage.

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A high income does not imply high wealth

A high income does not imply high wealth

Statistics shows that a high income does not mean high net worth

In our previous article, “Household income and wealth in Australia”, we examined the progress toward financial independence being made by the wealthiest 20% of Australian households, with wealth measured alternatively by household net worth and household gross income. We found that the net worth measure of wealth was a better indicator of current financial independence than was household gross income.

The official statistics [1] on which our analysis was based clearly reveal that a high income does not imply high net worth. In fact, they indicate that only about 34% of households that rank in the top 10% by gross household income also rank in the top 10% by household net worth.

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Borrowing to buy property within Super: Buyer Beware!

Borrowing to buy property within Super: Buyer Beware!

Just because you can doesn’t mean your should

Borrowing to buy property within a Self Managed Super Fund (SMSF) has been promoted by many within the advice industry as an exclusive opportunity you should seriously consider. And, while there can be occasions where this strategy makes sense, as a general rule the fundamentals just don’t stack up.

Back in 2007, the Government opened the door for SMSFs to borrow. The change was driven by the popularity of investing in instalment warrants (such as Telstra’s T3 offer). These investments had an element of gearing which created some confusion under the no borrowing restrictions of the Superannuation Industry (Supervision) Act. To over come this, the Government decided to remove the borrowing restriction.

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Don’t fall in love with your employer

Surely, I’m better off investing in my employer’s sharesDon’t fall in love with your employer

Many employees hold shares (and/or rights to buy shares) in their share market listed company employer. The interest may have been acquired as part of their remuneration package or as compensation for sale of a business to the employer. Or, perhaps, the employee was optimistic about the prospects for the employer and bought its shares as an investment.

Often, there are restrictions imposed on dealing in the shares, at least for a specified period after acquisition, so the employee has no alternative but to retain the position. However, even when there are no restrictions, many employees continue to hold and, over time, build substantial (but minority) interests in their employer.
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Employee Share Schemes – Are the proposed changes all bad news?

Tax and employee share schemes
For many, receiving shares or options from your employer is a welcome benefit. There are usually no immediate tax or cash flow implications and you simply get access to a new investment that, hopefully, will grow in value.

The May 2009 budget proposed changes to the treatment of these benefits which are likely to affect both the issuance and immediate implications of employee share schemes in the future.

Currently, as a recipient of shares or options under an employee share scheme , you get the choice on when to pay tax on the benefit you receive. If you do nothing, you will be deemed to defer the tax until a later date (the “cessation time”). Alternatively, you can elect to pay tax on the discounted benefit upfront by making an election in your tax return.
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