What would you do if you were given R2 million and told you had to invest it in property?
You might think of buying a nice flat in Cape Town’s southern suburbs that you could rent out to students. That should give you an attractive yield in what seems like a good location.
But what if something unforeseen happened – the complex became a drug den, for example, or the bottom fell out of the student accommodation market because the university decided to move all its classes online?
You would suddenly find yourself holding an asset that is worth a lot less. It would also be more difficult to rent it out.
However, what if you took that same R2 million and invested it in a global property unit trust? You would then have exposure to dozens of different companies that own properties all over the world, operating in sectors from hotels to data centres. Even if one of those companies ran into trouble, or one of those areas hit real problems, the rest of the portfolio would still be okay.
This example illustrates the basic reasons for diversification. Neither of these options is an intrinsically good or bad investment, but by buying the unit trust you would be exposed to a wide range of assets, which lowers your risk and reduces your chances of suffering big losses.
Investors might recognise this intuitively, but it is still something that can catch them out.
Consider what happened in Finland over the past two decades. At the top of the market boom in 2000, Nokia had become so successful that it made up 70% of the market capitalisation of the Helsinki Stock Exchange. If you had just bought that index, you were therefore actually buying a very concentrated portfolio. The performance of just one stock determined its fortunes.
In this case, the outcome was pretty dismal. Nokia’s share price reached a high of over €62 in 2000, but by 2012 it was worth less than €2 per share. As a result, the Finland Stock Market Index fell 70%. Even today, it is more than 35% below its 2000 peak.
Investors might think that investing in the market as a whole will mean that they are diversified, but this isn’t always the case.
Having just one stock or industry or even country dominate your portfolio is called concentration risk – the risk that one factor will have an oversized impact on your wealth.
And you can be exposed to concentration risk in different ways. Just because you’ve bought a number of different shares, for example, doesn’t necessarily mean that you are truly diversified.
If your portfolio is made up of 20 different technology stocks, you might think that means you are avoiding the ‘all your eggs in one basket’ problem. But if the whole technology sector loses value, and all the shares go down together, having 20 of them isn’t going to help you.
In the same example, it is also possible that just one of your technology stocks – Tesla, say – might make such rapid gains that it suddenly becomes the bulk of your portfolio. That also carries risk.
Between the start of 2020 and October 2021, Tesla’s share price went up 14 times. This was just about the greatest investment anyone could have made.
But, unfortunately, too much of a good thing can still be a bad thing. Since the start of November 2021, Tesla’s share price has lost 70%. And for investors who had most of their portfolio invested in Tesla, this has had a big overall impact.
For South African investors, one more thing to consider is how much of your wealth is concentrated in the country you live in. If your home, your job and your pension are all based here, you probably need to think about diversification.
This is not just a local problem. Since everyone prefers what is familiar to them, investors all over the world have a bias towards their home country.
But as South Africans we not only have country specific problems like loadshedding and political uncertainty, we also have a very limited stock market. That makes it a good idea to think more globally so that your portfolio isn’t overly impacted by what happens here.
Investing internationally also means that you can get exposure to companies and sectors that you might not find on the JSE, like technology or renewable energy. And that will help diversify your portfolio even more.
To discuss your long-term investment strategy, speak to a professional.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.