Last week, we saw how investors could buy shares at different prices in order to bring down the average price of their holdings to more acceptable levels. This time we are considering the benefits of diversifying their portfolio. We can look at diversification from many angles. Someone who works in the oil and gas industry should ideally hold most of his investments in non-related industries, for example, information technology, retailing or banking companies. Doing so would help him counterbalance the risks and returns inherent in his industry. Another way to look at diversification is from the point of view of a small businessman operating, say, a printing establishment. From his perspective, he would want to ensure a steady and diverse stream of customers for his business. One way that this could be done is by wooing and acquiring customers from different economic sectors, for example, insurance and banking services, food retailing, motor car sales and real estate.
In doing so, he tries to ensure he is not overly dependent on any one economic sector for most of his sales. In addition, when one sector is experiencing difficult times, he can step up his sales efforts to another sector. Applying this principle to the ordinary investor, we often hear the saying that we should not place all our eggs in one basket. In essence, this means we should balance our shareholdings so that when one segment of the economy is experiencing difficulties, the value of our holdings of other shares in different companies should be sufficiently large to counteract that negative effect. In general terms, we should own shares in different companies operating in diverse sectors of the economy. Some examples include banking, insurance, conglomerates, trading, manufacturing and property. Examples of these companies are easily found on both the local and regional stock exchanges. Further afield, one can find technology, utility, motor vehicle and transportation and mining companies operating globally.
Personalised portfolio
An easy way to achieve some diversification is to invest in a mutual fund, particularly in a growth and income fund. This type of collective scheme owns shares in a diverse range of companies, locally, regionally and sometimes internationally. The fund may also own corporate or government bonds. In order to take advantage of the principle of average costing, discussed last week, regular monthly or quarterly contributions are encouraged. For example, instead of making a one-time investment of say $100,000, it may be better to invest say $10,000 and $1,000 per month for an extended period of time. While there are many conveniences to using a suitable mutual fund, the major disadvantage is the fees charged by the fund manager and other parties for their services. Over time, these can seriously erode an investor's primary returns. A different approach to building a diversified investment portfolio is to meet with a stockbroker or financial planner to help build a personalised portfolio that reflects your personal interests, needs and unique priorities. Using this one-on-one approach allows you the flexibility to buy investments that are of greater interest to you and, equally important, avoid those which you have little interest in owning.
A further advantage of a customised approach is you have the flexibility to indulge in unique investments opportunities which you feel could generate a huge one-off return, preferably in a relatively short space of time. In this regard, consider the following example. Angostura Holdings Ltd was suspended on the stock exchange due to its failure to submit audited accounts for 2008. The suspension lasted from July 13, 2009, and was only lifted on February 14, 2011, when it was able to finalise its audited accounts for 2008 and subsequent periods. In the first few days after trading resumed, the share price fell relentlessly as many, probably small investors, sought to sell their shares. The price closed on March 1, 2011, at $5, where it stayed until March 31, 2011. During those periods, 730,240 shares changed hands at the same $5 per share. Then, on April 1, 2011, as more buyers returned to the market, we saw the price move up to $5.01. On April 4, 2011, 678,026 shares traded at $5.01.
Thereafter, persistent demand, fuelled by the recognition that the share was probably undervalued, pushed the price up to a peak of $10 on May 11, 2011. At that point, the share probably seemed slightly overvalued and short-term investors may have spotted an opportunity to cash out, so its price slowly declined.
After much improved results in 2010 and 2011, Angostura paid a 12 cents dividend for 2011. Its share price was recently quoted at $8.39. Some short-term investors may have already sold their recent purchases at prices between $8.50 and $9.25, reaping a handsome profit. Investors who bought this share at $5 are probably quite happy with its current share price and they have a reasonable expectation of getting increasing dividends in the coming years. This example shows what may be gained by being alert to the occasional mispricing opportunity that can occur from time to time.
Mediocre returns
One may speculate that the reason for the persistent fall in the share price in the first six weeks or so after the resumption of trading may have been some investors' urgent need for cash at that time; no doubt, this might have had something to do with the fallout from the Clico/CL Financial matters. Some may argue that too much diversification of one's portfolio essentially results in settling for average or mediocre returns over the investor's time horizon. Then, why not use an appropriate index fund? This is where an investor's risk appetite and risk capacity come into play. Some advisers like to pigeonhole investors into a specific generic group. For example, they may say that individuals under, say, the age of 30 years, holding a steady job and with no family responsibilities should be able to take huge risks with their money. They argue that this group would have another 30 years or so to be able to recover from any significant losses they may incur. For this group, they might recommend speculative shares, real estate, futures, even commodities. At the other extreme, individuals over the age of 60 years might be pigeonholed and ushered into very conservative investments, such as income funds, government bonds and similar safe instruments. Recommending such conservative investments may be a disservice to this group; with increased longevity, an investment portfolio should have a reasonable element of solid equity investments, which alone can assure some measure of growth in the portfolio. Without understanding a particular individual's ability to handle risk and uncertainty, an adviser may recommend inappropriate investments. Another consideration is the individual's capacity to assume risk, that is, his ability to sustain a particular level of loss combined with his ability to recover from any loss over a reasonable period of time.
Active investor
In most cases, the owning of investments is essentially a passive activity, that is, the investor is not involved in the day-to-day running of the enterprise. Consequently, he would not normally have any influence over such important decisions as marketing, cost control and pricing of the company's products or services. Essentially, he really has no control over the company's destiny, save and except an occasional question or recommendation at the company's annual general meeting. Despite this small limitation, these instruments can play a useful role in bettering the investor's financial health. For some, the best investment is starting and managing one's own business. For the rest of us, we have to learn to use (with or without external help) available investment products well enough to navigate our finances to a comfortable level, while not incurring too many setbacks in the process. This should be the essential focus of our diversification efforts.
