OUR grannies used to tell us not to put all our eggs in one basket. Extending the metaphor, putting all our baskets on the same truck won't help if the truck crashes or gets stolen. I'm talking about diversification – but what does it really mean?
Is it simply not putting all your equity investments into the shares of a single company? No. Investors who bought Lehman Brothers, Bear Stearns, AIG, Merrill Lynch, HBOS, XL or any one of countless companies that seemed like a good investment at the
time have seen their investments disappear. Buying several of these companies wouldn't have helped.
It isn't just lack of skill or knowledge that causes investors to buy shares which end up worthless. Even the so-called experts get it wrong. In 1999 Fortune magazine recommended ten shares with "the size, stability and earnings power to carry investors through whatever the market throws their way in the decades to come". Since then two of their tips have gone bust and another two have lost around 90 per cent of their value. Only one actually made a profit.
Perhaps investors would have done better placing all their money in property? Only a few years ago investors were sucked into making property investments on the back of a massive speculative boom market. Nobody believed they could lose money on bricks and mortar. We all know what has happened to property values recently.
Surely placing money in a savings account would have been a better idea? Well, recent events have shown that cash carries risk too. In fact all investments carry risk. Risk and reward are inextricably linked. Everybody knows shares should give investors a higher return in the long run for accepting greater risk. However, few people understand that the same applies to banks.
Interest rates on cash have been abnormally and unsustainably high for some time. The reason banks are paying such high rates of interest on deposits is that they desperately need to draw in money to strengthen their shaky finances. The banks with the weakest foundations need to pay the highest rates of interest to encourage savers to deposit with them. The latest run on HBOS shares made depositors acutely aware of the risk-reward trade off.
What should investors do? Diversify! Diversification is the only game in town and the closest thing to a free meal an investor can get. But true diversification isn't as easy to find as it may first appear.
Take the banks for example. An investor attempting to spread their risk by opening accounts with the AA, Birmingham Midshires, Halifax, and Saga would not have diversified at all as all of them are regulated via the Bank of Scotland. Total compensation would be limited to only £35,000 if all of those brands went bust.
When it comes to equities, full market exposure to both the UK and overseas markets is required, using low-cost index tracker funds or ETFs (exchange traded funds) where possible.
Investors need to spread their portfolio across all of the major asset classes of cash, fixed interest, property and shares but stay clear of so called alternative assets such as structured products, hedge funds, commodities and fine wine, all of which add unnecessary risk with little reward.
If it seems too good to be true -it usually is.
• Alan Dick CFP is a certified financial planner, chartered financial planner and principal of Forty Two Wealth Management.
The full article contains 590 words and appears in The Scotsman newspaper.
