In his speech to open the Griffith University Personal Finance and Superannuation school last month, one of Australia’s leading experts on the superannuation system Professor Michael E. Drew continued his decade-long campaign to shift our thinking about how we invest from focusing on promises to looking at reliable outcomes.
If we did this, he believes there would be less focus on volatile “growth” assets, and more focus on constructing portfolios that generate predictable returns for investors.
One year returns as widely reported this week were good across a number of sectors and reminded me of Professor Drew’s comments. The ASX200 ended the year 12.35 per cent higher but just seven companies CBA, Westpac, BHP Billiton, ANZ, NAB, Macquarie Group and Telstra accounted for more than half of all the gains.
Holding a share portfolio of the four major banks, Macquarie, BHP Billiton and Telstra is concentrated and high risk from a portfolio management perspective. There are another 193 stocks in the ASX200; even in a concentrated share portfolio investors should seek diversification across sectors. The GFC showed us that banks are cyclical, sometimes get into difficulty and are not immune from economic cycles; share prices can fall and dividends can be cut.
Instead of looking backwards at historical returns to help make investment decisions, a more productive approach is to stop and think about the outcome you want to achieve. Providing certainty of a minimum cashflow in retirement to meet everyday living expenses and having a little on the side for travel or eating out would serve many investors well. Others may include preserving a lump sum for descendants, providing an education trust or lump sum to a favoured charity, which are all worthy outcomes. Your individual desired outcomes list may be quite long.
Identifying the path to achieve your outcomes is the problem. The financial industry is made up of many participants, largely focused on returns or outperformance over a benchmark. They cannot possibly know your individual targeted outcomes, so that is why they focus instead on historical percentage returns.
A portfolio concentrated on any single asset class will be more susceptible to economic cycles. Diversifying across asset classes will help smooth returns and minimise shocks, to better enable you to achieve your desired outcomes. For example, one of the major benefits of investing in bonds is that they are generally counter-cyclical to shares. That means they move in opposite directions given specific market conditions.
An allocation to each of the three types of bonds (fixed, floating and inflation linked) will help protect your capital under various economic cycles. Of course, some high risk corporate bond prices will fall in a distressed market, but assuming the companies survive, investors have the surety of a positive return and getting capital back if they hold the bonds until maturity.
A truly diversified bond portfolio would hold allocations to the full range of risk and rewards available by entity, throughout the capital structure and across industrial sectors and would include government and high yield bonds. Under a GFC scenario, higher risk bond prices would fall but there would be a corresponding flight to quality and we would expect government bonds to outperform, cushioning overall returns.