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Over-eating a free lunch?

By Mary Holm

Monday 27th May 2002

Text too small?
Diversification, says a new AMP publication, "is the investment equivalent of laughter or fresh fruit - something that you can never have too much of." Nice line. But I think the writer got a bit carried away.

The quote comes from item number two, "Diversify, diversify, diversify", in a list of "Five Investment Principles".

It goes on to say, "In principle, investors benefit from having their assets spread as widely as possible."

Risk can be reduced by diversifying: between growth and income producing assets; geographically, by industry; by company size; and in listed and unlisted securities. It also suggests "considering both government and corporate bonds".

This is all good stuff. If you have wide-ranging investments, you're not going to be unduly upset when one does badly.

Also - and this is important - diversification reduces the volatility of your total investments without reducing your average expected return.

In response to economist Milton Friedman's famous line, "There's no such thing as a free lunch," fellow economist Peter Bernstein countered that diversification is, in fact, a kind of free lunch. You gain without loss.

In that case, surely AMP is right. The more free lunch, with lots of fresh fruit, the better.

The only trouble is, the article lists as its fourth principle, "Keep investment options simple and understandable".

"Complex products," it says, "invite misunderstanding and investor disappointment". And I couldn't agree more.

I've heard many sad tales of people who signed up for complicated investments that offered - but certainly didn't deliver - high returns at little or no risk.

Ask a disillusioned investor how they thought the investment would work and they say, "Well, I wasn't too sure. But the numbers looked really good." Complexity makes it easier to bamboozle.

But AMP's fourth principle isn't only saying stick with what you understand. It's also saying keep things simple.

And that doesn't match up with unlimited diversification.
Not long ago, this column ran a letter from a reader who had invested in 14 managed funds.

That's great diversification - but also lots of paper work and calculations to work out how well he was doing. Either that or a financial adviser was doing it for him, and no doubt charging a monitoring fee.

You can gain a large degree of diversification with just a few investments.

Those with, say, less than $50,000 for long-term investment could choose one wide-ranging New Zealand share fund, an international share fund, and term deposits or government bonds. If they own their own home, that's enough in property.

With more money, the range might include a smaller company share fund, corporate bonds or a bond fund and a non-residential property fund.

If you choose well, you don't need multiple investments in each of those groups.

As Henry David Thoreau said, "Our life is frittered away by detail ... simplify, simplify."

Oh yes, and AMP's other three principles?

- Know how much risk you can cope with.

"New Zealanders tend to have short investment horizons compared with investors in other similar countries.

"Our analysis shows that on average, over a 10-year horizon, we expect the returns from higher risk assets, such as shares, to be about twice those of income-producing assets such as bonds."

- Keep expenses, such as fees and taxes, low.

- Stay the course.

"Investors often jump ship at precisely the wrong time." They buy what's recently risen and sell what's recently fallen.

"United States data suggests that over the past 15 years this has cost the average investor at least one third of the returns they would have achieved had they kept their investment mix constant."

Apart from my quibble about diversification, I can't argue with any of it.


Mary Holm is a freelance journalist and author of "Investing Made Simple", commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached at maryh@pl.net. Sorry, but she cannot respond directly to readers.

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