As investors, we all want our investments to grow and deliver higher risk adjusted returns despite the prevailing economic environment brought about by the cyclical nature of investments markets due to varying macroeconomic factors like politics, inflation, country growth and others. For long-term successful investment, it is important for an investor to have and adhere to an investment plan, and one fundamental pillar of that plan should be an asset allocation that ensures portfolio diversification, and which is aimed at attaining the investors’ objectives.
So how do we go about constructing a diversified portfolio? To start off, we first have to consider an analysis of the investor’s investment objectives and constraints in order to inform the investment strategy. This planning step involves taking a number of factors into consideration, but primarily the following 7 factors:
- Risk: This is the probability that an investment may not earn its expected rate of return. For investors, it is of paramount importance to figure out your risk tolerance level i.e. your capacity to take on risk, and not just your willingness to bear risk. Generally, the approach is usually to conform to the lower of the investor’s ability or willingness to take on risk,
- Return: This is the expected earnings from an investment; they include dividend, interest, rent, capital appreciation etc. To get return is an investor’s ‘raison d’etre’; the reason why people invest. Generally, the higher the risk an investor takes on, the higher the expected return, and the lower the risk, the lower the expected return,
- Liquidity: This refers to how quickly an asset can be converted into cash without a significant loss in value. An investor who requires regular cash flow to fund possible spending needs may require liquid assets to be held in their portfolio,
- Investment Horizon: This refers to the period that an investor intends to hold an investment and it is dependent on the investors’ income needs and risk exposures. In general, the longer an investor’s time horizon, the more risk and less liquidity the investor can accept in the portfolio,
- Sophistication of the Investor: This refers to how knowledgeable an investor is in terms of investment products and their capacity to invest. Usually, investment products are classified into retail investment products and institutional investment products, with some investment products being suitable for all classes of investors, while others are tailor made to target a specific class of investors,
- Tax situation: The tax treatment of various types of investments is also a consideration in portfolio construction. Some investment accounts like pension accounts may be tax exempt, hence investors with such accounts can choose fully taxable securities to hold in their portfolios. For accounts that are fully taxable, investors may opt for investment securities that are taxed at lower rates, e.g. investing in equities for capital gains that are usually tax exempt or taxed at lower rates,
- Unique circumstances: Each investor may have specific preferences or restrictions on which securities and assets that they can invest. These can range from ethical preferences, religious preferences or restrictions placed on investing in rival companies.
After analyzing an investor’s investment constraints, the next step is to construct the investment portfolio, taking into account the need to diversify. Diversification is a risk management technique that aims to minimize risk in a portfolio by spreading investments across a range of securities and asset classes, with the notion that a single negative event will not adversely affect all securities held in the same way and to the same degree. Diversification comes from the time-tested analogy - “don’t put all your eggs in one basket”. The rationale behind this contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment within the portfolio. Where an investor has significant conviction on a certain asset class or security then one can hold a more concentrated portfolio.
In order to diversify your portfolio, you can invest in a variety of asset classes, which include:
- Fixed Income: Fixed income securities are securities that promise to pay a given return to an investor, in the form of coupon payments and repayment of principal on maturity. These securities include Treasury bonds and bills, corporate bonds, corporate debt issues and fixed deposits in financial intuitions. Fixed income securities constitute the largest investable asset class, with a large number of institutions and investors participating in the loaning out and borrowing of funds in fixed income markets. Key characteristics of fixed income securities that make this asset class appeal to investors under various macroeconomic conditions include:
- Fixed income securities cover short to medium term investment horizons, and exhibit low volatility, as the payments are defined and periodic, and hence suited to investors who desire stable returns and are risk averse. This makes fixed income securities desirable during periods of uncertain economic performance and more so Treasury instruments,
- Interest rate risk- Fixed income securities are highly susceptible to changes in interest rates, due to the value of such securities falling with rising interest rates as the opportunity cost of holding such a security declines. Thus, when interest rates are rising, more investors are attracted to the fixed income market owing to higher yields.
The main thing to get right is to ensure that at all times the investors understands the risk levels of the issuer and ensure their ability to pay is sound.
- Equities: Equities refer to ownership of interest in an entity in form of common or preferred stock. Investors who wish to acquire a stake in a certain company do so by buying shares from the company during an Initial Public Offer or from existing shareholders who wish to offload their investment. Other than capital gains, equity investors also stand to gain from dividends declared by a company if they are in the shareholders’ register at the time of book closure. Key characteristics of equities that make this asset class appeal to investors under various macroeconomic conditions include:
- Liquidity- Listed shares are relatively liquid in that investors can easily convert their investment into cash for immediate use within a short period depending on the trading settlement cycle and investors can easily accumulate and exit their positions without a significant loss in their invested value,
- Volatility- Shares are the most volatile asset class as market forces of demand and supply determine the value of a stock. This characteristic makes equities preferable for long-term investors who can hold the stock through the short-term volatility, until the stock price attains its intrinsic value. This characteristic also makes equities appealing when there is positive macroeconomic news as optimism among investors usually results in a rise in stock prices.
As investors buy into companies, they should ensure that they understand the long-term prospect of the company and they buy in at the right valuations. Always good to know that a good company does not automatically translate to a good stock, and conversely, a bad company does not automatically translate to a bad stock, we have to factor in valuations.
- Real Estate: Real estate is an attractive alternative investment, offering investors the chance to get long-term, stable and attractive returns, which also provide a hedge for inflation. Investment in real estate refers to investment in property for returns, which could either be residential, commercial, retail, hospitality, medical properties, among others. Investment in real estate is in the form of (i) development of real estate to get returns and profits from the development, (ii) investment in completed developments for yield and capital appreciation, and (iii) investment in listed real estate through a Real Estate Investment Trust (REIT) or listed real estate company. Real estate is suitable for long-term investors, with the returns being more attractive as compared to other asset classes. Key characteristics of real estate that make this asset class appeal to investors under various macroeconomic conditions include:
- Diversification – The inclusion of alternative investments in an investment portfolio tends to result in lower overall volatility of the portfolio, as the portfolio benefits from a greater selection of investment options. In addition, real estate investments do not move in tandem with the public listed markets, hence has low correlation with traditional investments, a factor that further enhances diversification benefits if part of your investment is in real estate.
- Superior Returns - Alternative investments have historically outperformed traditional investments. For example, real estate which is an alternative investment asset class, has consistently proven to outperform other asset classes in Kenya, as in the last five years it is projected to have generated returns of 25% p.a., compared to an average of 12.2% p.a. in the traditional asset classes.
- Structured products: Structured products are investments that require one to identify certain market anomalies and within the regulations come up with a product that helps investors attain the best returns. Structured products are supported by the performance of an underlying asset, and the structuring involves adding layers or features to traditional products in a form that meets an investor’s needs, which would not be met from the standardized financial products broadly available in the market. Generally, they are traded in the private markets to qualified or sophisticated investors through alternative investment managers such as private equity managers.
- Others: Derivatives and Private equity investments are other types of investments. Though complex, they have the potential of delivering higher than average returns on a risk-adjusted basis.
Diversification has many proven benefits, however, it does not guarantee an investor protection against a loss. In addition, diversification does not reduce the systematic risk of investing in a particular market. This systematic risk is what is referred to as non- diversifiable risk or market risk. It is the risk not associated to a particular company or industry. Non- diversifiable risks include (i) inflation rate risk, (ii) exchange rate risk, (iii) political instability risk, and (iv) interest rate risk. They are the risks investors must accept willingly in order to invest.
In conclusion, the potential complexity associated with considering all these factors in an investment strategy requires a disciplined approach. This can be challenging especially if you are not involved in investment management on a daily basis and hence the need to partner with an investment professional, who will assist in coming up with your own specific investment portfolio. The first step could be the generation of an Investment Policy Statement (IPS). The IPS serves as a strategic guide to the planning and implementation of an investment program, and is highly customized to meet specific investors’ investment constraints. The investment professional should also help with the actual construction of the portfolio and security picking. In addition, the investment professional will periodically review your portfolio to allow for rebalancing back to your target allocation. Investors should take an active role in managing the portfolio to analyze their individual investments and determine if they are worth holding, since a well-diversified portfolio reduces risk without sacrificing returns. At all times investors should have an inquisitive approach to investments to ensure the partner understands where they want to get to and if there are any changes in circumstances, they are captured quite early.
On the run up to the elections we saw many investors taking a wait and see approach to investment, with most of them holding cash and cash equivalent investments, which have lower risk and stable returns. However, some investors saw this as an opportunity to jump in on the perceived riskier assets like equities and real estate at an attractive price. As can been seen from the performance of the equities market, the index has really gone up with NASI increasing by 4.3% during the week, and we expect to see a strong come back in the real estate sector as well.
For investors, getting the right investment partner is key to achieving one’s investment goals. Also making the right investment decision at the right time goes a long way alongside diversification in getting the best returns.
