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 FINANCIAL
PLANNING FIB #5
Diversification is like
mothers' milk in the finance industry. If
you had to nominate one financial strategy
that everyone can agree on, it's probably
that diversification is a good thing. Most
financial planning firms will have a brochure
extolling the virtues of diversification,
usually with a nice picture of eggs in different
baskets on the front cover.
So what could be wrong with that? Nothing
in theory. The problem is how to get
diversification efficiently in practice.
The first thing to note is that spreading
your money with a range of fund managers is
not diversification; it's just spreading your
money with a range of fund managers. Let's
say you wanted to invest in a portfolio of
Australian shares. You receive a statement
of advice recommending that you invest in
four funds: the ABC Gold Fund, the XYZ Bullion
Fund, the Acme Precious Metals Fund and the
Eldorado Yellow Metal Trust. Is that a diversified
share portfolio? In terms of the gold sector,
maybe yes, but you wouldn't have any exposure
to the other 96% of the local stock market.
What if the statement of advice recommended
eight different funds that covered nearly
every sector of the stock market. For example,
funds that specialise in growth stocks, value
stocks, industrials, resources, gold, large
caps, mid-caps and small companies. Surely
you couldn't get more diversified than that?
That's probably true and it's quite common
to see real-world financial plans with exactly
this kind of recommended portfolio. But what
has been achieved by covering every market
segment with eight different fund managers?
Let's start with the growth and value stock
funds. History and logic suggest that these
funds are very unlikely to do well at the
same time because they're like opposite poles
on a magnet. The same is true for industrials
and resources, and to a lesser extent large
cap and small cap stocks.
All the planner has done here is create a
portfolio which will almost guarantee you
a return that's close to the market index.
And if that's the case, why are you paying
2% a year in active management fees? You might
as well invest in an index fund for less than
half the price.
The combination of diversification and active
funds management can end up a bit like an
expensive, non-alcoholic cocktail. There's
no point diversifying so much that all the
active managers cancel each other out.
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