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On Wednesday I told you about what could be a very handy addition to your portfolio: A great income play that could beat inflation. And it set off quite a lively debate.
I was talking about the Balfour Beatty 10.75% convertible preference share. Not only does it pay a decent fixed yield, but holders also have the option of converting it into equity. As I explained on Wednesday, that could be a great 'get out of jail free' card if we head into an inflationary spiral.
But as one reader pointed out, “If you’re worried about inflation, wouldn’t you be better holding Balfour’s equity in the first place?”
Well, yes – that’s a fair observation. But it does miss a key point which I’d like to get across to you today…
The point of this exercise – ie, adding fixed interest to regular shares – is diversification, or spreading risk. And diversification is deeply misunderstood.
In fact, there are two types of risk you need to diversify against and understanding both types is critical. It could mean the difference between a comfortable retirement and penury.
Diversification is not just buying lots of stocks
Diversification is typically explained using that old saying, don’t put all your eggs in one basket . As such, most investors see the merit in spreading investments around. If you’ve only got five stocks in your portfolio, you probably ought to consider more, or buying a pooled fund. If you’ve got a hundred stocks, you’re almost certainly over-egging it.
I think a good, sensible number to hold is something like 20 or 30 investments. That’s enough stocks for most people to follow. And studies suggest once you’re over 20, you’ve gained most of the benefit of diversifying stock and sector risks. But there’s another type of risk that’s often ignored. It takes a little more imagination.
To expand the earlier metaphor a little further, this type of diversification not only puts your eggs in different baskets, but it then sends your baskets off in different directions. Let me explain...
We’re not only vulnerable to individual sector, or stock risks. We also face macro-economic and political risks (the ‘big picture’ threats to our money). I’m talking about inflation, or deflation. Interest rates, tax changes, legal changes, or perhaps, even the collapse of the financial system as we know it.
The things that could torpedo your entire savings pot
Nobody knows what the future holds. Nobody! That’s why you have to try to make sure your portfolio attempts to diversify away some of those unknown risks.
I mean just consider this: it wasn’t so long ago that sovereign bonds were deemed to be risk-free. In fact, many elegant investment models were based on that very thesis. Not anymore!
The way I see it, the things that could torpedo your whole retirement fund are macro-economic and political risks – these are the game-changers. Think about the Japanese retiree that put his pot into equities in 1990, only to find 20 years (and counting) of falling stock prices. Think about the poor blighter that put it all into supposedly safe government bonds in the early seventies only to see his retirement fund trashed.
I could cite plenty of other examples that include currency disintegration or other forms of regime change.
Because we can’t be sure what the future holds, we need to set up our portfolios with a diversified approach – NOT just diversified by the number of investments. But diversified for different socio-economic outcomes, too.
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"Bankrupt Britain?"
There are many paths for your eggs to travel
Putting your eggs in different baskets isn’t enough. Not when you’re planning a fund that may not be drawn down for decades. We need to send our baskets off in different directions too.
By all means have some in a pension fund – that’s fine and it’s tax efficient. But just be aware there are political risks in doing it. Remember, big pension pots look very attractive to governments in trouble. It’s no longer just a banana republic phenomenon – we’ve already seen it happen in Hungary and Ireland. And even the Royal Mail’s pension fund has been under attack from our very own government.
We can put some money abroad too – for me, international diversification is a must. Some countries are in better shape and will grow better than others. Certain currencies will be stronger too.
But let me get back to my Balfour preference share...
Because as well as socio-political risks, the main ‘big picture’ factors we need to account for are inflation and deflation risks – and the implications for interest rates.
As I’ve said in The Right Side many times, I’m inclined to think that our ultimate destination is inflation – which pushes me towards inflation hedges like commodities and equities. But the truth is I can’t be sure of what's coming our way.
Perhaps we’ll suffer Japanese-style deflation – where rates stay negative and so do returns. Or perhaps we’ll get our inflation – but what if interest rates remain in lock-down anyway?
How I spread my assets
That’s why I maintain my broad asset allocation as: 25% equities; 25% commodities; 25% fixed interest stocks; 25% cash (and cash equivalents).
Despite my long-term fears for inflation, I still hold 25% of my lot in fixed-interest stocks.
And that includes the Balfour Beatty preference share. It’s insurance against a perma-low interest rate scenario (and might I add economic misery). The fact that these prefs can later be converted into equity is just a bonus.
If, come 2020, it turns out that inflation was indeed the outcome, it means I can change my mind about my fixed-interest allocation. I can convert my prefs into Balfour Beatty equities – potentially at a very good price. But that’s a secondary consideration.
Macro-economic diversification is what I’m after here – and I wouldn’t get that by holding Balfour Beatty equities.
Today’s ‘takeaway’ lesson is that holding loads of different stocks is only half the diversification story. How your portfolio reacts to broader macro-economic and political threats is the other half.
It’s worth totting up all your assets and really thinking long and hard about how your wealth may react to different macro threats.
And with that in mind, next week we’ll bring housing into the mix. We’ll look at how property can be used to diversify your savings pot.
In the meantime, two things you might have missed in the past week. Both are proving very popular with Right Side readers looking for ideas to build their portfolios.
1. “More profitable than gold bullion… and much safer than tiny gold explorers” – is this the best way to play the next leg of the gold bull market? This expert believes it is.
2. If you’re looking for some great growth stock ideas, check out the Big Pharma ‘profit channel’. These two could make you big money. Click here to get the story.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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