Bringing Perspective to the Investment Environment.

What’s needed is a wide-lensed approach, that does not rely on antiquated understanding of markets, but ensures appropriate diversification across the investable environment.

Building an investment portfolio is like creating an oil painting. There needs to be a sense of depth and perspective for it to be a success. A portfolio that lacks a three-dimensional profile has returns that are dull and flat, like the primer coat on a painter’s canvas.

So the challenge for investors is to determine how best to devise and implement a well-diversified and properly proportioned portfolio. It’s like building a portfolio that is as well-rounded as a sphere.

For centuries it was widely believed that the earth was flat and seafarers lived in fear that if they sailed too close to the ends of the earth they would plummet over the edge. The ‘Copernican revolution’ helped to change that perception when it was realised the earth is shaped like a ball and the planets in our solar system revolve around the sun.

Investors need their own Copernican revolution to gain a proper sense of perspective. To do this it is helpful to first be an appropriate distance from the object being studied. The earth is clearly spherical when observed from afar by an orbiting satellite. However, from such a substantial distance much of the detail about the earth’s topography is only vaguely defined. There is just a mixture of blues, greens, browns and yellows.

Viewed from an appropriate distance a well-balanced investment portfolio should appear as a mixture of Australian and international shares, property, bonds and cash. The exact proportions in each asset class within a person’s portfolio will vary from one individual to another depending upon their particular goals and objectives. However, in all cases it is absolutely essential that investors obtain this perspective first if they are to understand the true position.

Once this broad understanding is achieved we can then move on to a more detailed examination of the characteristics of each particular asset class. We are now much closer to the object being studied but still at such a distance that we can see the forest for the trees so our understanding is not obscured.

This ‘helicopter view’ allows us to recognise that Australian and international shares can be grouped into large, small and value categories in the same way that we might separate oceans, fertile land and desert. Small and value companies have more risk than large companies and as a result it is reasonable to presuppose that they should offer a higher expected return.

From our vantage point we can also distinguish that not all fixed interest securities are alike. Some have a shorter period to maturity than others and depending on the state of the economic cycle they may offer a lower or a higher risk and return than longer-dated securities.

Also, some interest-bearing investments carry more credit risk than others because there is a higher chance that the borrower may default. It is generally inadvisable to take such risks in a well-proportioned portfolio. The riskier investments should be reserved for holdings in shares and properties.

Having found a clearing in which to land our ‘helicopter’, we set out on foot to examine at close quarters the features of our surrounding environment. We find thousands of species of trees in the same way that we find thousands of different shares on stock markets around the globe.

There are countless varieties of fauna and flora, which are all essential to the health and well-being of the ecosystem. In the same way, our highly diversified portfolio should encompass the vast array of investment options: large and small companies, short-term and medium-term bonds, industrial, commercial and retail properties. These are all essential to the success of the portfolio in the form of reduced risk and high returns.

Beyond this is yet another world which we can only see through the magnifying glass and the telescope. This is the world populated by atoms, protons, neutrons and helixes. Although we are barely aware of its existence it is essential to our survival.

As investors most of us do not feel that it is essential we understand in minute detail the workings of the financial system, - sharemarkets, bond markets, currency markets, money markets and so on. We take comfort in the knowledge that the existence of these ecosystems ensures the success and survival of our investment portfolios.

What’s needed is a wide-lensed approach, that does not rely on antiquated understanding of markets, but ensures appropriate diversification across the investable environment.