Investment guide for 2009: diversification

Last week we started the discourse on the forces of risk and return as the two major factors every investor who intends to succeed in the investment world in 2009 must come to terms with. I had explained the weaknesses and strength in the different classes of assets. This week we will be looking at how to create a balanced investment portfolio through good diversification.

You’re almost certainly familiar with diversification, but it is also one of the most misunderstood investment concepts.

Diversification is one of the most commonly discussed topics among all types of investors-from those just starting out to the largest money managers on Wall Street. The reason: “Diversification is, without question, one of the keys to your success as an investor, “But you must employ it correctly”

As an investor, it’s crucial to ask yourself two important questions about your portfolio: Am I truly diversified? And am I taking advantage of all the strategies at my disposal to capture the full range of diversification benefits?

True diversification

The basic idea behind diversification is simple: Don’t put all your eggs in one basket. That said, simply owning a large number of stocks or other investment doesn’t automatically make you diversified. The key, is to spread your capital across a wide variety of asset classes and asset styles that have fundamentally different risk and return characteristics.

Such investments typically behave differently from each other during a market cycle-bonds often perform well during periods of stock market weakness, for example, while some international shares might rally when the Nigerian market falls.

By combining different types of asset classes, you can enhance your portfolio’s return potential, while simultaneously lowering its overall level of risk.

These advantages can be especially important for investors looking to preserve what they’ve earned. For example, consider an executive whose wealth is concentrated in his or her company’s stock. “The same stock that makes an investor wealthy can also damage that wealth if it runs into trouble, as within the past six months with many companies and CEO’s” If one of your goals is to preserve your capital, diversification is an absolute must. Feelers reaching us have shown that the world’s richest men are not immune to the mess caused by the financial crisis because of poor diversification. It was recently carried in a national daily that virgin Nigeria might be running into cash flow troubles; this is a company that Richard Branson would have easily assisted in times past if the cash was there.

Diversification is a useful technique that can reduce overall portfolio risk and volatility. Diversification neither ensures against a profit nor protects against a loss. Each investment type has different investment and risk characteristics. Bonds, treasury bills, treasury certificates and other money market instruments have fixed principal value and yield if held to maturity. Bonds have market risk, interest rate risk and credit risk. Stocks can have fluctuating principal and returns based on changing market conditions. The prices of small company stocks or penny stocks generally are more volatile than those of large company stocks this is evidenced by the significant losses witnessed in the insurance sector of the Nigerian stock exchange in 2008.

Asset allocation

One of the most effective ways to diversify an investment is with asset or fund allocation, and it is a good way to help smooth out volatility in your portfolio.

How does asset allocation work? Different asset classes (such as stocks, bonds, properties) may respond differently to the same market conditions. This means if one part of a diversified portfolio does poorly it can be buffered by other investments that do relatively better. In other words, asset allocation helps spread the risk over several investments. The key to asset allocation is investing in assets with dissimilar performance. While the scientific and measurable investing principles of asset allocation are sound and are well proven, up until recently the process required some detailed mathematical calculations.

A properly diversified portfolio within the Nigerian economic terrain should include investments in a variety of industries and asset classes such as cash, stocks, government bonds, fixed annuities, insurance policies, real estate, and personal business endeavours. A Detail study of these different classes of diversification for a Nigerian investor will form the focal point of our discussion in the next edition.

INVESTMENT GUIDELINE FOR 2009

You are welcome to 2009, I want to wish you a happy new year and my sincere prayer is that the Almighty God will see you through the year. During the course of the Christmas and New Year break I took time to reminisce on the events that took place in the financial markets in 2008. For example, all of us are aware that as far as the stock market is concerned 2008 was a year that you and I will not forget in a moment because it was dominated by the bears.

Dear friend, irrespective of all the challenges that we had witnessed in the capital market in 2008, it’s important for you to know that a new year has come. It’s time to get over the past and make new strategies for the challenges and opportunities that lie ahead which form the focal point of this article.

Stock market and general financial crises are recurrent phenomena in different generations, so it is inevitable. The most important thing is knowing what to do when we face financial challenges and that is why I want to congratulate you if you are reading this article because it will definitely open your eyes to common sense financial principles which a lot of us have broken and have paid seriously for.

HOW TO INVEST WHEN THE MARKET IS DOWN

1. Risk and Return: the forces of risk and return are two major factors you must put into consideration before investing your money in any venture this new year. Risk and return are twin brothers that are inseparable and in the financial world they have what we call a direct relationship, which means, the higher the return expected from an investment the higher the risk attached to it, also the lower the return expected from an investment, the lower the risk level will definitely be.

I want to appeal that you come to terms with these two major factors that will determine how successful you are financially in 2009, because investors who have ignored these forces, have had their fingers burnt and you reading this article might have been a culprit at one time or the other in the process of taking investment decisions.

I will explain these two major forces better by using the various classes of investments we have and how these two factors affect them. The classes of investments that yield the lowest return in Nigeria today include government bonds, treasury bills, fixed deposits and many other instruments that yield interests. As low as the return being generated from these instruments may seem, the level of risk attached to them is quite low; an investor who puts his money in any of these will, at least, be assured that he will get the principal invested back. Let’s take a look at the capital market that most of us are familiar with.

In Nigeria, the major instruments traded in the capital market are shares or stocks as some people call them. Shares are volatile financial instruments whose prices can go up or come down; they are not interest yielding instruments and are very different from the classes of investment earlier mentioned. At every time the prices of shares continue to go up or down, they are not meant to be static, and as a wise investor your major priority is knowing the factors behind these upward and downward gyrations so that you can take steps to safeguard your investment accordingly. But the painful observation I had made is that many investors who put their hard earned money in the stock market assume that stocks can only go up and not down, this is a wrong assumption.

The third dimension to viewing the forces of risk and return by a Nigerian investor is by considering the case of wonder banks like Sefteg, Wealth Solution and others. These wonder banks promised investors returns as high as 500 to 1000 per cent within a space of time. Most of these schemes did not stand the test of time because they have broken the same financial principle that I am sharing with you now. I actually found it funny when investors started complaining when these illegal fund managers folded up. My answer to the whole issue was very simple and I really need you to think about it very well: “If a scheme can promise the highest return within the shortest possible time, shouldn’t you be ready to face the music if all your funds are lost in the process, just because of that same financial law which states that the higher the return from an investment, the higher the risk will be.”

Dear readers, always take these two factors into consideration when it comes to investment and financial decisions you will be making in 2009 and years to come. They are basic laws in financial management that most investors often ignore but I want you to come to terms with them and apply them appropriately. I have shown you the weaknesses and strength of different forms of investment, in the next issue of this weekly, we will consider other financial principles that will guide how you invest in these trying times. Happy New Year!

Jide Ogunleye is a chartered accountant, and CEO, Denaro Capital Ltd.