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Investing: This is why you diversify and don't focus on picking winners

A ‘winning’ asset class this year can easily disappoint next year, John Berry warns.

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Over 2021 New Zealand’s housing market and US shares were both up strongly, nearly 30 per cent. Meanwhile the price of Bitcoin rose by twice as much.

But not all investment returns were so rosy with New Zealand’s stock market, emerging markets shares, and gold each down marginally for the year.

The lesson from this is not that you should have had all your money concentrated only in high performing Bitcoin. Nor should all your savings only be in residential property or in US shares. The wide spread of returns across different investment types, and how these change from year to year, tells us we should diversify across asset classes, geographies and industries.

When investment is concentrated in only one asset, and it pays off, it can be a great outcome. But is this success be attributed to skill or to luck, and can it be repeated the next year?

Picking the winning asset class year after year requires perfect timing and foresight. A ‘winning’ asset class this year can easily disappoint next year.

New Zealand’s share market and gold are great examples, delivering healthy returns over 2019 and 2020, before a flat 2021. Past returns are not a guide to future returns.

A well-constructed portfolio should include the full range of asset classes, like shares, bonds, property and alternative assets. If you have strong investment views or expertise in any area, you can actively underweight or overweight that asset class.

Don’t limit your diversification only to spreading across asset classes, diversify within asset classes as well.

Looking at US shares, the 27 per cent return for the S&P500 last year was not even across all sectors. Information technology and financials were both up around twice as much as utilities and consumer staples.

Diversifying spreads risk, and also averages returns across your portfolio holdings. It is possible to add value by actively overweighting and underweighting exposures. (Warning: it is also possible to destroy value if you get those calls wrong).

Overweighting or underweighting also applies to ethical preferences. You can choose to avoid weapons or fossil fuels, or can choose to overweight renewables or companies that show more care around environmental and social issues.

Tesla’s share price fell over 2018, finishing the year at US$66. Since then it had three years of remarkable returns and the share price is now over US$1000.

But you can’t risk concentrating into only one stock, because it might be like A2 Milk. It had a great run, growing strongly to its peak in mid-2020. Its share price has since fallen about 70 per cent following disruption from Covid-19.

Unless you have special stock-picking skills, or you believe you’re blessed with incredible luck, or you have money you are prepared to gamble, don’t concentrate all your money chasing what you think is the next Tesla. Diversifying asset classes, geographies and industries is the best way to balance expected portfolio risk and return for 2022.

-John Berry is co-founder and chief executive of ethical fund manager and KiwiSaver provider Pathfinder Asset Management, the first B Corp certified fund manager in New Zealand which is part of Alvarium Wealth. Pathfinder uses active investment strategies.

(This article was originally published by Stuff January 20, 2022)

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