Even if you are convinced that your one big investment is the “best one by far”, you can get excessively burnt if and when the unexpected happens.
There are dozens of examples where good hard working people have somehow or other ended up with most of their eggs in one basket, and have made needless losses.
The problem often arises when an investment has been really successful and you are “attached” to it. You know that diversification is essential, but somehow you don’t.
It does not matter really what sort of investor you are, you will do better in the long run if you;
- continually review your assets
- continually rebalance
- make sure you understand and practice diversification
- preferably own a mix of uncorrelated assets with some that may rise while others may be static or falling (e.g. bonds and shares )
- ensure you have some investments that are liquid so you can access them in emergency
- be aware you cannot rely on your income always being there
- remember you cannot rely on tenants to always pay the rent, and sometimes you cannot get a tenant
Even the “safest” asset can be adversely affected by a bad tenant, flood, earthquake, economic downturn, imported diseases such as PSA, government actions, new taxes and so on.
Smart investors will ensure they are diversified, rebalance often, and have access to cash (liquidity) in emergency.
Rebalancing is a very handy tool, since all it really requires is two steps, plus some discipline.
Number one is to decide on what proportion of your assets you want in each asset class.
Number two is to regularly ensure that you stay within those proportions.
Peter has his own home worth $500,000 and has had 2 rental houses for nearly 25 years, which have grown in value from $150,000 to $400,000 and $125,000 to $350,000.
A good result but the problem is that is Peter’s investments are not diversified – 2 houses in the same town, and he has little else invested. He has an average income, is not too far off retirement, and the property has just become debt free.
He knows lots of people who have been hit by the GCC and often because of a lack of diversification.
He also has some friends in Christchurch who were slammed by the earthquake, so he is feeling somewhat unsettled about his lack of diversification.
What should he do?
Although he loves property and has done well from it, he decides that in future he will have;
- 25% of his money in bonds, on and offshore, since they are liquid, low risk and pay income
- 50% of his money in property since he loves it and understands it
- 25% of his money in shares, mainly offshore, for the purposes of diversification, potential growth, and liquidity
He decides to sell the property with the lesser potential.
He then invests the proceeds 25/50/25.
He keeps a close watch on his new 25/50/25 asset allocation.
Initially the shares are flat and then suddenly they have a sharp rise and represent 32% of his assets.
He takes the profit off the top and reduces his share holdings back to 25% of his assets. He puts the profit into either his income account, or his property maintenance account, or buys more bonds
Property has a big surge and so represents 60% of his portfolio. He reviews his property holdings, decides to sell, and buy something cheaper. He now thinks he prefers low maintenance units and so buys two of them instead of a house.
Much later on
His wife contracts very nasty health condition and he needs $50,000 urgently for treatment. He can easily access this cash from his bond and share portfolios.
As life would have it, about the same time his son runs into financial difficulties and need some cash. Again he has access to cash and is able to help.
Over time he has also been nicely surprised to find that bonds and shares have served him well too.
This article was supplied by Alan Clarke who is the author of a book entitled “Retire Richer” which is a practical guide for everyone age 25 to 85. –
Alan also writes a regular blog on www.investandretire.co.nz
Alan is an authorised financial adviser (AFA) and his disclosure statement is available on request and free of charge.