Hit for six Economic & Investment Update – March 2014

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Too much of a good thing

This article originally published in The Northern Daily Leader on 1 March 2014.

Everybody eventually figures out that there really can be too much of a good thing. This wisdom usually comes with age, with children generally refusing to believe that too much ice-cream, lollies or soft drink can ever be a bad thing. When I was a teenager I held the same view about prawns – there could never be enough grilled prawns dipped in tartare sauce. Until a dinner-time special at a local restaurant – 50 prawns for 50c each – taught me that there was indeed a point at which too many prawns became a bad thing.

The investment world has its own version of ‘too much of a good thing’. An important rule in investing is to apply the principle of diversification. It’s both a combination of common-sense – why would you invest all of your life savings into just one or two companies – and of sound scientific basis – research has shown that appropriately diversified portfolios out-perform under-diversified portfolios under any set of circumstances and across just about any time period you wish to consider. There is, however, diversification which results in the most appropriately diversified portfolio and then there is diversification for the sake of diversification. A recent new client arrived with an investment portfolio which consisted exclusively of Australian shares; around 50 of them in all. It sounds like it was a diversified portfolio, but just like the prawns, simply increasing the quantity does nothing for the quality. Many of the companies were inappropriately speculative and the exposure to individual sectors and industries appeared haphazard and indiscriminate. It was almost as though they had been previously advised to buy 50 random shares out of the available list of around 2,000 listed companies and throw them together in the hope that it resulted in a diversified portfolio. Not only that, but besides a small bank account, there was no other exposure to any other asset classes. International investments? None. Fixed-interest investments? None. Anything else at all besides Australian shares? Nothing.

Even ignoring the lack of alternative asset classes (which in itself is a failure to diversify), the sheer number of companies in the portfolio achieved little. Once you have more than around 25 to 30 shares in your portfolio, adding additional companies to your portfolio has only a marginal impact on your portfolio’s level of diversification, with the trade-off being higher transaction and administration costs. You can keep adding to your portfolio beyond this point but it achieves little, beyond helping your stockbroker fund his next Ferrari. Diversification across asset classes however, is even more important. Research has found that in general, it’s not what investment you hold that matters, it’s what asset class you have exposure to that matters. But that’s a story for another day.