The days of investing solely through "superior stock selection" are at an end. As Irish investors become more sophisticated in their strategies, they look beyond the risks of stock-picking to managing risk through diversified, balanced investment portfolios.
Although new investors may believe diversification means holding more than a couple of stocks, successful veterans know spreading a mix of asset types like stocks, bonds, property and cash across various industry sectors and geographic regions offers the best protection against negative economic and market forces.
A portfolio is a collection of investments. Although portfolio theory is a relatively new concept in Ireland, investors are becoming more comfortable with the idea. "We're in the very early stages here," says Mr Dara Fitzgerald, portfolio manager for Hibernian Investment Managers. "Wealthier individuals are very experienced, but the mass market is only beginning to move away from low-risk trackers and deposit funds."
Often the first step in reducing risk is investing in pooled investments like mutual funds, unit trusts and unit-linked funds. "It's a toe-in-the-water position," says Mr Fitzgerald. "They begin with cautiously-managed funds, then as they grow in wealth or experience they may choose a managed fund with a higher equity content."
The fund or funds then serve as a base from which to build a larger, more diversified portfolio that includes stock, bond, property or sector funds. Since these funds are managed by investment professionals they are already diversified and require no attention regarding the individual products in the fund. The fund manager makes the decisions regarding market timing, diversification and asset allocation in line with the objective and risk profile of the fund.
As an investor becomes more knowledgeable they may wish to take a more active role in the portfolio and include investments in individual shares or products. However, it is always advisable to employ a professional fee-based investment adviser to assist with these decisions.
According to Mr Fitzgerald, a portfolio may be started with as little as £2,000 to £5,000. Despite the amount invested, adopting "modern portfolio theory" always involves several steps to ensure risk is minimised while return is as consistent as possible.
Risk and return
When building a portfolio, an initial conversation with an investment adviser should begin with a discussion of risk versus return. Through a list of basic questions, the professional adviser determines the customer's investment profile. Age, financial liquidity and home ownership usually contribute to the assessment. Younger people tend to be aggressive or moderate investors as they have time to ride out market fluctuations. However, the need for mortgage capital may change their profile. Those nearing retirement age are often conservative investors as the capital must be protected for future income.
Diversification
For decades, investment firms have hired teams of analysts to stock-pick using internal company analysis, earnings projections, balance sheets and other factors to determine that company's future. Research and analysis are far from hocus-pocus and play an important part in selecting stocks. However, this process is only one of many factors in building a portfolio.
A diversified portfolio is the realisation of the proverb "Don't put all your eggs in one basket". Diversification may occur in several ways - across geographic regions like Europe, Asia and the United States and into industry sectors such as banks, building, chemicals, consumer goods, life assurance, oil, property, pharmaceuticals or technology.
This variety reduces risk by levelling out the highs and lows of the overall portfolio's value. For example, if a portfolio consists of stocks and bonds from several regions, a dip in any of these economies will not drastically affect the return of the overall portfolio. The same protection occurs if a particular industry is hit by a downturn. Over time, controlling risk in this manner usually means consistent returns.
Asset allocation
Another way to diversify your portfolio is through asset allocation where assets are divided into types (stocks, bonds, property, cash) and weighted according to your risk profile. Usually conservative investors have a higher percentage of bonds within their portfolio, while those able to tolerate a greater degree of risk need a higher percentage of stocks.
Research has determined that portfolio performance is most affected by asset-class selection, according to investment expert Mr Larry Chambers in The First Time Investor. Mr Chambers claims that 94 per cent of performance is attributable to asset allocation, 4 per cent to stock selection and just 2 per cent to market timing.
Investors moving from deposit accounts and single stocks to diversified portfolios should not be afraid to ask questions of their advisers. It is particularly important to establish the fees incurred initially and over time for various investment types.
As the investment mindset changes, more products will come on-stream to suit investors' particular investment level and needs.
However, Mr Fitzgerald says: "People should not invest all of their assets, only what they're comfortable with and then they may build on it over time." says Mr Fitzgerald.
Investment watershed
The Telecom Eireann flotation marks a turning point in the attitude of Irish investors. These once conservative, deposit or guarantee-based investors are moving their cash into the share offering in huge numbers. Loans from banks and building societies have increased, while deposit accounts are drying up.
"The Telecom Eireann share offering is the first time people actually have to pay for all their shares," says Mr Fitzgerald. Everyone wants a part of the potential gains in the stock market but avoid the reality of the associated risks.
"We're concerned that people get too excited by just one share. It's an education process and they should consult independent advisers as shares by their very nature carry a degree of risk," says Mr Fitzgerald. Fortunately, some individuals are adding this single share to a larger investment portfolio or strategy.
