How to choose investments that fit your life

Why does choosing investments that fit your life matter? Find the balance between diversification and concentration.

The importance of diversification is one of the first lessons investors learn. It has been called the 'only free lunch' in investing. However, over-diversification can lead to diluted returns.

There must be a balance between diversification and concentration risk. Concentration risk is the equivalent of putting too many of your eggs in one basket.

As Australians, many of us are too concentrated in the local market. Exacerbating this risk, the Australian stockmarket is concentrated on two main industries - financial services and mining.

Further, we derive income from the Australian economy. All of a sudden, we have most of our super and investments in the Australian economy and our income is derived from the Australian economy.

This is one example of concentration risk. Other examples would be concentrating your investments in one particular manager or in one investment, such as a house. It is an understatement to say that Australians are obsessed with property. Houses come up whenever investing and personal finance are discussed.

Affordability, the best places to buy and how to get into the market are common themes.

Many Australians' wealth is concentrated in the illiquid asset that is their primary place of residence, and according to the Australian Taxation Office more than two million of us have further concentrated our wealth through investment properties.

A survey commissioned by Raiz Invest in 2019 suggests that Australians have no problem with this: 53% of participants don't believe cash is the safest place to invest money and 22% believe property is the safest investment. Whichever assets you hold, concentration is a risk for investors to manage.

How to judge the right level of concentration for your goals

One of the main questions to ask: What is the balance between concentration and diversification?

How many shares should I have in my portfolio? Investors need to ask themselves, if the value of any investment or security dropped to zero, would it prevent me from reaching my goals?

This is the risk you need to balance. Many financial commentators and professionals see 12 to 18 stocks as a safe number because it diversifies the risk while maintaining enough concentration for each holding to have a decent impact on returns.

Practical steps to building a portfolio An academic example of a diversified portfolio will always contain a mix of many asset classes - cash, international and domestic fixed income, alternatives, international and domestic equities.

Gold, crypto and commodities might be added to the mix. You can always find an argument to add another asset class in the interests of diversification. In reality, such a complicated mix is often not necessary.

What a diversified portfolio can look like in practice

Diversification is the process of removing single-security risk from a portfolio. Once that is accomplished, many investors pick and choose which asset classes and investments will best help them reach their goal.

The goal of removing single-security risk is not the justification you often hear for diversification.

Instead, many in the investment industry like to talk about buying uncorrelated assets - that is to say, assets whose values don't move in lockstep. Taken to the extreme, holding negatively correlated assets means prices move in opposite directions.

The reason the investment industry talks up uncorrelated assets goes back to the idea that volatility is synonymous with risk. Uncorrelated assets lower volatility in a portfolio; a negatively correlated asset acts as a hedge.

There may be very specific reasons why an investor would want to lower the volatility of a portfolio or hedge it. It shouldn't be the default move, however. Remember, it is important to avoid the mindset that says being a great investor involves holding a complex portfolio. Being a great investor means you accomplish your goals.

You don't lose any points for doing that in the simplest and safest way possible. We think the benefits of simplicity outweigh those of complexity.

Keeping track of a complex portfolio is time-consuming and rebalancing a complex portfolio can be difficult. Adding new contributions to your portfolio can be challenging as your holdings grow since you will need to decide where to funnel new savings.

As we've reiterated, most investors lower their returns by trading too much. More holdings increase the temptation to tinker, risking your goals.

Why simplicity often beats complexity in real portfolios

Research from Morningstar shows that portfolio diversification doesn't have to be complicated. A simulation with a basic mix of 60% stocks and 40% investment-grade bonds was compared with a portfolio that held 11 different asset classes.

The more complex portfolio was made up of 20% large-cap domestic shares, 10% developed and emerging markets stocks, government bonds, US core bonds, global bonds and high-yield bonds, and 5% each in small-cap stocks, commodities, gold and real estate investment trusts (REITs).

Although the more diversified portfolio outperformed at times, the 60/40 mix provided better risk-adjusted returns in about 87% of the rolling 10-year periods since 1976. This is great news because it means you don't have to overcomplicate your portfolio. It doesn't take much to achieve the right mix with adequate diversification.

Your job is to find investments that will help you meet the return and asset-allocation requirements that will achieve your goal. Your investment strategy will include security-selection criteria that provide a framework for picking from the thousands of available investment options.

How many ETFs and funds make sense for most investors

One of the most common questions we get is about quantity. How many stocks should I have in my portfolio? How many ETFs? How many funds? Let's start with ETFs and managed funds.

A simple portfolio involves a single ETF for each asset class to which you want exposure. For most investors shares and a single defensive asset class such as bonds or cash will probably suffice. Australian investors will typically want one ETF for Australian shares and one for global shares plus a defensive asset class.

An army of investors termed Bogleheads follow the advice of Vanguard founder John Bogle. He advocated for the simplicity of a three-ETF portfolio for the reasons we've outlined.

A portfolio needn't be limited to just three ETFs but as an investor you should consider seriously the justification for adding any and every additional holding.

It may make sense to do so based on your goals and investment strategy. Just be sure there is a high hurdle for including asset classes such as emerging markets, small-cap shares, a thematic or factor ETF or any of the countless other offerings.

How to pick shares that actually diversify your risk

When it comes to equities, there are many professional investors and financial firms that provide guidance on how many shares are adequate for diversifying away risk.

The number ranges from 12 to 30 but the number alone, without context, is meaningless. It's the shares themselves that matter - the sectors, industries, geography.

Consider this when picking the shares in your portfolio, especially in Australia with its concentration in the two industries of mining and financial services. Because Australian investors have a great sense of home bias - they like to focus on Australia - many of them are invested in one geography and mostly across two industries.

To sum up, don't overcomplicate your portfolio and do have your investments directly connected to the goals of your portfolio. You don't need a stake in every single asset class to be diversified.

Exercise: set diversification rules that fit your goals

You are on the pathway to a personalised investment strategy based on your goals. As part of your strategy, you will establish rules around diversification.

A precursor is framing diversification around the goals you have already defined.

Start with asset classes

Think through which asset classes you want in your portfolio and why.

We suggest you start high level and consider global and Australian shares, global and Australian bonds, global and Australian listed property and cash. You shouldn't just own something for the sake of owning something. Look at the returns in different asset classes over the long term and compare them with the returns you need to achieve your goal.

Think about the role you want an asset class to play in your portfolio

Consider whether other options would achieve the same end, especially if they are cheaper to access or work better with the other assets in your portfolio.

Write down which asset classes you will consider and which you won't, along with your rationale for these choices. This will be an input into setting your asset allocation as part of your investment strategy.

Consider the individual holdings in your portfolio

If you use or plan to use funds or ETFs in your portfolio, this step is less critical. Funds and ETFs are already diversified, so you don't need to set a specific rule around holdings. It is perfectly reasonable to include one ETF or fund per asset class in your portfolio. If you hold or plan to hold individual shares, there are other considerations.

Think through position sizing or the percentage of your total portfolio that each share can make up.

The risk you are trying to diversify away is that of not achieving your goal. Use that as the basis for your decision making. If a position that makes up 5% of your portfolio were to go to zero, could you still achieve your goal? If not, that holding is too large.

One trick to help you as you complete this exercise is to go back to the calculation of your required rate of return.

Reduce your portfolio

Don't change any of the other variables but reduce your current portfolio size by different amounts that represent size limits of a position. How much would it change your required rate of return if you were to reduce your current portfolio by 5%?

Could you make up for this change by saving more money to maintain the current required rate of return? You don't need an exact number. Aim for a comfortable range for an individual share as a percentage of your portfolio while protecting your goal from a catastrophic loss.

Write down the range for each position and your rationale for selecting it

This will be an input later. Finally, consider any other aspects of your goal that may influence diversification.

For instance, if you are an income investor you may want to limit the amount of income that comes from any one share. Think through any other components of diversification that are related to your individual goal.

This is an edited excerpt of Invest Your Way by Mark LaMonica and Shani Jayamanne. Enter now for your chance to win a free copy!

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