Investing by its very nature is all about attempting to understand current markets and take positions in the future.
As this is a difficult task, it is better not to rely on one’s ability to get this consistently right. However, in order to be an investor, positioning for an unknown future is all part of the deal.
So, Investing 101 will always say do not rely on one position, but rather take a few positions (investments) as chances are at least one of the ‘bets’ taken on an unknown future will be one full of regret. To use investment terms, diversify your portfolio and be prepared for some of your assets to perform better than others.
But how should an investor diversify? Are there rules of thumb, such as the minimum or indeed maximum number of investments one should hold in a diversified portfolio?
Opinion varies here, however, my strong view is diversification is not a function of the quantum of investments held. Effective diversification is all about understanding investment markets are dynamic and contain a number of risks, with these risks both growing and shrinking at various stages of an investment cycle and an investor’s time horizon. Put simply, ensure the assets held in a portfolio are sufficiently different and that they respond to various risks differently.
This short article will discuss the benefits of holding both real and financial assets together in a portfolio.
Financial assets are assets that are listed and trade on a public market and usually have a price set daily, which we refer to as mark to market. Think assets such as listed equities and listed bonds. Real assets are assets that do not trade on any public exchange. Think unlisted property, unlisted infrastructure and private equity here.
Holding listed and unlisted assets together provides extremely powerful diversification benefits. The key reason being they are driven by vastly different dynamics.
Listed assets, at least over the short term, are affected by sentiment and weight of money. In other words, if investors are feeling optimistic, they invest (buy), meaning a weight of money is pushing up prices. Conversely, when confidence is low, we see lots of selling, which depresses prices. The price movement can be either consistent or inverse to the trajectory of the underlying business.
Unlisted assets run more to the beat of their intrinsic value and are affected far less by sentiment. Yes, there are different ways to value unlisted assets and we have seen inappropriate valuation methods used during periods of stress. The key thing though is the performance of listed versus unlisted assets occurs at different points in the investment cycle.
Listed assets react to where the economy is heading a lot quicker than unlisted assets. This is because investors are trying to predict where the economy is heading and trying to position their investments accordingly. For example, if we are at a high point in the economic cycle, with strong growth and falling unemployment, it is not uncommon for listed assets such as equities to start to perform poorly as investors try to position for rising interest rates to head off an inflation threat.
Real assets will still be performing well as the underlying economy is strong and demand for their services is still strong. Additionally, they are not affected by the sentiment of what is to come via rising rates and hence the weight of money, which shifts the value of listed assets. This manifests in part of your portfolio, real or unlisted assets, doing better than the other, listed assets, part of your portfolio.
This is the intended outcome of diversification. The risk of inflation and rising interest rates has affected part of your portfolio more than another part of your portfolio. This, however, is a dynamic that might apply in the short term, but will not necessarily apply in the long term.
Ultimately, the performance of assets over the long to medium term will reflect their inherent quality. So, a bad business whose share price gets pushed up in the short term as individuals clamour to invest while they are feeling overly confident will see its share price corrected when people ultimately pay attention to what they have invested in.
Similarly, unlisted assets might give investors relief near term if listed markets are being savaged due to negative investor sentiment, but this will correct if the unlisted business ultimately is a poor business to invest in.
So, in conclusion, the secret of successful diversification is to select assets that are so different they perform differently at various points of the investment cycle but have sufficient quality to perform well over the medium to long term. This means a well-diversified portfolio will see fewer big swings in short-term performance while providing healthy long-term returns.
Capital Prudential’s Secured Income Notes offers an excellent diversification opportunity. This investment provides returns that are less affected by sentiment or weight of money, with the returns more driven by the profitability of the property developments held. They are better immunised from the periodic often short-term shocks of sentiment and weight of money shifting markets. Hence, they will better shield a portfolio when negative sentiment eats into the performance of listed assets.
This information is for wholesale clients only. It doesn’t take into account your objectives, financial situation or needs and you should consider whether this is right for you.
Michael Fazzini is sales and distribution executive at Capital Prudential.
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