Aussie investors putting too many eggs in the local basket
Australian investor portfolios tend to be too narrowly focused across a few dominant sectors and may be missing out on international opportunities.
When it comes to diversification, the 11 million Australians holding investments outside of their superannuation fund still tend to place all their eggs in one basket. Up to 75 per cent of share owners hold only Australian shares, according to the latest ASX Australian Investor Study. Forty per cent of investors say they don't have diversified portfolios, while 15 per cent don't know. And among Morningstar Premium subscribers, 60 per cent say they hold no overseas investments.
That's not to say Australians are wholly blind to the benefits of spreading their bets. Nearly 8 per cent of the adult population say they directly hold shares listed on an international financial exchange, up from 5 per cent in 2014. But Australian retail investor portfolios "are not very diversified", according to the ASX survey, and investors' awareness of financial products "declines quickly outside of shares".
As we will see, Australian portfolios tend to be too narrowly focused across a few dominant sectors. Knowing the benefits of diversification can help reveal new opportunities, and help you avoid constructing a portfolio that is too concentrated and potentially vulnerable to a domestic downturn.
Avoiding 'home bias'
Home bias — or the favouring of domestic shares — is by no means unique to Australian investors. There are good reasons why equity investors around the world favour their home market. In 2016, Australia's S&P/ASX 200 outperformed other developed equity markets, and last year reached a historic market capitalisation of $1.8 trillion. In this context, the imputation credits earned by holding shares in locally listed companies are an alluring tax incentive for Australian investors.
One reason that explains — and perhaps exacerbates — such home bias is the recent global uncertainty, dominated by Britain’s decision to leave the European Union, the election of Donald Trump in the US, and lingering investor scepticism in the wake of the 2008 global financial crisis. Such events only add to the appeal of the local market and the already perceived barriers to international asset classes.
On a more subliminal level, a greater familiarity with local versus foreign companies also influences the decision of many investors to stick with domestic equities.
Therein, however, lies a potential pitfall. For if the Australian market is associated with franking credits, it is also renowned for being small and heavily concentrated. Collectively, the financial and mining sectors account for about 60 per cent of the ASX All Ordinaries Index. That's a lot of eggs in one basket. "The Australian share market only represents 2.5 per cent of global markets," note Morningstar's global director of capital markets and asset allocation Philip Straehl and his Australian counterpart James Foot. "This is most prevalent among financials (inclusive of real estate) and materials companies as these dominate the index exposure. The high level of cyclicality inherent in most of these sectors exacerbates the risks."
Australian Tax Office figures indicate less than 1 per cent of Australian self-managed super fund assets are invested directly overseas.
Diversification does not eliminate the risk of investment losses, but a multi-asset portfolio can provide a better hedge against economic and market outcomes. As Straehl and Foot note, "there are more levers to pull, including better risk controls and an ability to secure cash flows over a full market cycle."
Aussie share market: a study in concentration
The concentration of sectors in the Australian market becomes more apparent when you compare it to a global index such as the MSCI World Ex Australia. In the ASX 300 for instance, financials account for 33 per cent of the index, whereas for the MSCI they account for 17 per cent. It's a similar story for materials, which comprise 18 per cent of the ASX 300 and just under 5 per cent of the MSCI. Conversely, information technology stocks account for less than 3 per cent of the ASX 300, and almost 18 per cent in the MSCI. "The Australian market remains unappealing compared to some investment opportunities available globally," note Straehl and Foot. "By positioning a portfolio in those areas displaying the most attractive reward for risk, a valuation-driven investor can reduce the cyclical bias and thereby add a cushioning effect on returns in down markets. This is a key tool we are advocating to reduce the impact of any valuation shock."
Morningstar investors aren't shying away from international shares completely. But recent data compiled by Morningstar paints a mixed picture of investor attitudes to diversification. According to the data, 45 per cent of Morningstar Australia retail investors use direct shares to gain international exposure. However, 50 per cent of investors expect that in a year's time no proportion of their investments (outside super) will be in overseas assets. And yet only 14 per cent said the outlook for the Australian market was better. The reason behind such thinking shows a blend of caution, pragmatism and ignorance. The top three reasons offered to explain this reluctance to invest overseas are: the currency risk (32 per cent); lack of knowledge about overseas markets (27 per cent); and the fact that dividends on international shares are not franked (24 per cent).
Benefits of diversification
The chief aim of diversification is to mitigate your level of risk exposure by spreading your investments over a range of assets. You can further diversify by ensuring these types of investments are varied. A portfolio containing shares and bonds — large, small, or international shares, and short-term and long-term bonds, government bonds, or high-and low-quality bonds — will put you on the path to diversification.
It's worth repeating that while diversification does not eliminate the risk of losses a mix of investments may insulate your portfolio when one investment turns sour. After all, shares, bonds, and cash generally do not react identically in changing conditions. Over the long run, it is common for a riskier investment (such as shares) to outperform a less risky diversified portfolio of shares, bonds, and cash. The benefits of diversification become more apparent over a shorter period of time, such as the global financial crisis. Share-heavy portfolios suffered large losses, while those that had bonds or cash experienced less severe fluctuations in value.
3 ways to diversify
The first way to diversify is to include a range of asset classes in your portfolio, for instance, shares, property, and fixed interest. Investing across asset classes can substantially alter your investing experience. Stocks may provide a greater return than bonds over the long run but are also more likely to suffer bigger losses. At times an investment weighted towards stocks can still perform worse than one weighted towards bonds, even over a long period.
Secondly, you can diversify within an asset class. Within Australian shares, for instance, you may buy shares in companies that operate in different industries such as mining, retail, biotechnology and banking. If you owned stock in a single company and the company flourished, so would your investment. But if the company went bankrupt, you could lose all your investment. To reduce your dependence on that single company, you buy stock in four or five other companies, as well. Even if one of your holdings sours, your overall portfolio won’t suffer as much. By investing in a fund, you're getting this same protection.
And finally, you can invest in other countries, such as the US, Europe or Asia, thereby curbing your home bias. Diversifying your portfolio beyond Australia can offer a much broader range of class-leading businesses — and there are various ways of gaining direct access to international equities. Restricting investments to Australia closes the door to potentially lucrative opportunities elsewhere.
Morningstar's approach to diversification
Traditional views of diversification are based on the correlation between different assets classes and are focused on creating a portfolio that contains asset classes that show little correlation. In other words, the portfolio contains some asset classes that are supposed to rise when other asset classes fall. That way there is less short-term volatility in the overall account value.
Morningstar has a more practical view of risk, defining it as losing money that can't be recouped. For investors, that’s the risk of not having enough money in time to retire or being forced to change your lifestyle so that your savings last throughout retirement. It's worth assessing your own view of risk and how fluctuations in your portfolio would affect your life. If you are investing for the long term and can cover any short-term cash outlays with an emergency fund, then perhaps your definition of risk matches ours. The less value that an investor puts on the correlation of returns of different asset classes, the more attention can be paid to building a portfolio of global investments that are trading at attractive prices compared to intrinsic value.
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Lex Hall is a Morningstar content editor, based in Sydney.
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