Diversification, Offshore Investment and Asset Allocation

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One of the most important goals for any investor is to avoid losing money, which can be achieved quite easily if you reduce your risk. However, investing only in low-risk assets will produce sub-par returns and may cause you to miss your investment goals.

This is why you will hear advisors repeating the same thing over and over again, diversify!

What this does is spread the risk across different asset classes so that, if done correctly, one asset class will outperform when the others underperform.

Take this example of the difference in performance of two different funds between February 2014 and the end of January 2022.

The gray line represents the returns of a fund that has 50% exposure to international equitieswhile the red line is for a fund with 50-60% exposure to SA shares. With a 27% outperformance versus the AS-focused fund, the benefits of offshore diversification were extremely beneficial. On an investment of 1 million rand, this represents 270,000 rand of outperformance.

Different strokes

A common misconception about diversification is that all you have to do is spread the risk across multiple asset classes.

However, each portfolio and diversification strategy will be different depending on the needs and priorities of each individual investor. And above all, the investment horizon of the investor.

I think if you have 10 or more years before you need your capital, there’s no reason you shouldn’t be 100% invested in stocks.

Your diversification strategy in such a case would then focus on different sectors or themes, as well as different geographies. As the chart above illustrates, having only 50% of a portfolio invested in offshore markets produced remarkable outperformance compared to locally targeted strategies.

The closer you get to retirement, the less risk you want to take in case the markets hit a speed bump. This can have a disastrous impact on your investments if you don’t have enough time before retirement for prices to recover.

I recommend that if you’re five years or less from retirement, you start reducing your equity exposure to the point that you have about 70% of your portfolio in cash and bonds.

Shorter investment horizons – if, for example, you’re saving for a deposit to buy a house three years from now – then you’d also want to diversify your portfolio. Again, I suggest a maximum of 30% in stocks and the rest in cash and bonds.

Diversification within asset classes

As already mentioned, 100% exposure to one asset class, such as stocks, makes sense under certain conditions. The times when this makes the most sense are when you still have a long investment horizon that will allow you to recover if the market goes down.

Besides diversification across sectors, you can get additional diversification by looking overseas. I think this is essential for South African investors to produce long-term outperformance.

The wider scope of investments and investment opportunities outside of the country is reason enough to spread your risks across borders.

Do not discount SA bonds

I’m certainly not advocating that you abandon all local assets, as there is still value to be found. Particularly in local bonds.

SA bonds are worth considering because, in real terms, they offer the best returns for what is a conservative asset class. Moreover, they are a great combination with offshore stocks as they are negatively correlated.

This provides the ideal balance in a portfolio that ends up giving the investor a smoother ride over the long term.

Money market and liquidity

Conservative assets like cash and money market investments are less popular due to the effect of capital-eating inflation.

It makes sense to have cash in local currency if it suits your lifestyle, but I would suggest holding no more than 8-10% of your portfolio in cash. Having cash on hand also provides the opportunity to take advantage of cheaper stocks in the event of a sharp market correction.

If you are prone to this, you may want to keep some cash aside to take advantage of occasional opportunities. This approach is not for everyone but allows the more adventurous investor to keep money available to invest without fear of upsetting the entire portfolio with a long bet.

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