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Dangerous liaisons: The peril of concentrated risk

Dangerous liaisons: The peril of concentrated risk

This article originally appeared in The Australian on 22 February 2020

Now that the business year has kicked off in earnest, I am finding fierce opposition to many of the core building blocks of well-diversified investment portfolios.

As a result I see many highly concentrated investment portfolios — in asset classes, investment styles and even individual shares. Such concentration in portfolios can be successful — due reward for the higher risk that is inherent in them.

But concentrated portfolios can also come a cropper — the darker side of higher risk.

In the current environment of low interest rates, investors have become particularly attached to high-yielding investments as they seek to achieve their target cash return.

This is getting harder to do: for the first time in two decades the risk-free interest rate is lower than inflation.

So investors find themselves allocating generously to high-yielding shares and real estate investment trusts as well as high-yielding hybrids.

For many investors, the idea of meeting their cash needs by realising capital gains is unacceptable. Investors do not want “to be eating into our capital”, notwithstanding the logic that total returns comprise both income and capital gains.

This fierce attachment to yield, wherever it can be found, is likely to get even more intense if the Reserve Bank cuts interest rates by a further 25 basis points at its April meeting, as remains likely in the face of weakened economic conditions arising from the bushfires and the coronavirus.

To put it plainly, strong attachment can lead to bitter disappointment when circumstances change. Investors are well advised to develop a degree of detachment from their portfolios by considering them as objectively as possible in the face of changing conditions.

So what are some of the typical attachments that can detract from well-diversified portfolios?

The single asset class

Investors often have a strong attachment to a single asset class. Property is a great example of an asset class that has zealous adherents who simply wouldn’t invest in anything else.

In contrast, bonds are often seen as undesirable. “We don’t understand bonds” and “the returns are not high enough” are often objections, even though the falling interest rate environment is wonderful for bonds and they have delivered returns at 4½ times the rate of cash over the past year.

The single sharemarket sector

Within asset classes investors might have a fierce attachment to a sector. Banks are a great example of this. Adherents retain high allocations to the banks due to their generous dividends, despite the recent history of poor business performance and even cuts in franking (ANZ is now only 70 per cent franked).

Opponents who focus on pre-franked total returns remain underweight in the sector and even exclude it from their portfolios. Property trusts are another example of strong views — they are a favourite of private clients but eschewed by many active equity fund managers.

The single investment style

Speaking of fund managers, investors can have fiercely held views about passive investing (in the market index) or investing actively.

While both styles offer degrees of diversification, at one end of the active spectrum concentrated fund managers (who may select only 20 securities out of a 200-security index) clearly offer less diversification. Passive investing has been a winner in recent years, while many active managers have failed investors: this is going to change.

The single fund manager

Staying with fund managers, investors can be fierce adherents of a style such as growth investing (holding “expensive” companies with strong growth profiles), while looking to value investing (holding “cheaper” companies with lower earnings growth profiles).

Growth has been the winner of recent times but again there is a clear history of cycles in style dominance.

There is also fierce attachment to views about whether Australian investors should invest globally.

Some investors still believe that when the call for their capital is in Australia they should not take any geographical or currency risk. Australian investors happily are blessed with the opportunity to invest in local companies who operate globally, thereby automatically opening up global opportunities.

Investors may have strong views about the size of company they wish to invest in and feel comfortable investing in a smaller number of larger companies directly and then using diversified products to gain access to small and micro-cap companies.

As we approach the tail end of an unprecedented run of economic expansion and consider the addition of greater private market assets to portfolios, investors’ fierce attachments to the daily liquidity offered by public markets also becomes a talking point.

The single share approach

Finally we all know that investors can fall in love with a single security. It’s hard not be in love with CSL at $320 if you bought it at $2.30! There is no guarantee that nothing will go wrong.

If you are an advised investor make sure your adviser has an open mind about the investment environment and emerging products that can help make your portfolio more resilient.

Be wary of formulaic approaches to portfolio construction.

And if you are a self-directed adviser, meditate on the benefits of detachment and objectivity, rub your eyes and take a fresh look at your portfolio to identify past (and possibly no longer helpful) attachments.

Sue Dahn is a partner at Pitcher Partners and was recently voted No 1 among Australia’s top financial planners in The List: Australia’s Top Financial Advisers.

The views expressed in this podcast are provided by Pitcher Partners Investment Services and do not represent the views of any other Pitcher Partners financial services licencees. Pitcher Partners is an association of independent firms. The advice provided to you is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. Accordingly, before acting on the advice, you should consider the appropriateness of the advice having regard to your objectives, financial situation or needs. If you wish to acquire a financial product, we recommend you seek advice from a Pitcher Partners Investment Services’ representative, and where applicable, consider the relevant offer document prior to making any financial decision. ABN 24 052 941 036 | AFS LICENCE NO. 229887
This content is general commentary only and does not constitute advice. Before making any decision or taking any action in relation to the content, you should consult your professional advisor. To the maximum extent permitted by law, neither Pitcher Partners or its affiliated entities, nor any of our employees will be liable for any loss, damage, liability or claim whatsoever suffered or incurred arising directly or indirectly out of the use or reliance on the material contained in this content. Pitcher Partners is an association of independent firms. Pitcher Partners is a member of the global network of Baker Tilly International Limited, the members of which are separate and independent legal entities. Liability limited by a scheme approved under professional standards legislation.

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