Should you invest in an asset class at a bad time in the market cycle just to achieve diversification? Jenée Tibshraeny asks Martin Hawes

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By Jenée Tibshraeny

Small time investors, I recently had a discussion at a dinner party that might interest you.

My 30-year-old friend (who we will call Hamish) proudly shared the fact he had started earning enough that he could afford to invest decent portions of his monthly income.

His plan was to keep minimal cash in the bank and invest large portions of his income in three Smartshares exchange traded funds – NZ Top 50, US 500 and Emerging Market.

Because Hamish doesn’t have any children and isn’t planning to buy a house in the foreseeable future, he was comfortable leaving his money locked up in the share market long term.

He believed he was spreading his risk because he was investing in funds that track the market, rather than individual companies. What’s more, the markets he is tracking are in different parts of the world.

Hamish was aware he had taken a high risk approach, but felt he was diversified enough.

This was when I (figuratively) threw a ‘investing 101’ textbook at him and pointed out his asset allocation was concentrated, so in the event of a global recession, the value of basically his entire portfolio would fall.

If during this time he lost his job, the small amount of cash he had would only cover his living costs for a couple of months, so he would probably have to cash in some of his devalued shares.

But then Hamish raised a good question – how should he diversify?

With interest rates low, he’d only get a measly few percent putting his money in term deposits.

As for the bond market – the minority of people who actually understand how this works, would say that buying bonds when interest rates are low and more likely to rise than fall, isn’t the best idea.

The question then is, should Hamish diversify even if it means investing in an asset at a bad time in the market cycle?

It was at this point I decided to bow out of the conversation and later “phone a friend” – Martin Hawes, authorised financial adviser and Summer Investment Committee chair.

Martin says Hamish is well diversified within an asset class, but needs to diversify across asset classes.

In other words, invest a small portion in bonds and keep some cash.

Martin points out that in the event of a major sharemarket collapse, good quality bonds (government and municipal bonds) are likely to increase in value.

Because an economic downturn is likely to see interest rates fall, bond yields will look relatively more attractive. The demand for bonds will therefore go up, as will their values.

But what about if interest rates rise – the more probable situation currently facing the global economy?

Bond yields will look relatively less attractive, so their demand and thus their values will fall.

(For more on the relationship between bonds and interest rates, see this page. And  here is a cautionary tale about buying long-term bonds with resettable, or floating, interest rates).

So is Hamish best leaving bonds out of the equation for now, allocating a larger portion of his portfolio towards cash instead?

Martin thinks not.

If he was Hamish, he’d allocate a small amount of his portfolio – say 10% – towards bonds.

He points out the value of bonds is that you can earn a taxable capital gain.

Martin believes there is still room for interest rates to fall, so in this scenario you could earn a capital gain you couldn’t earn from a term deposit.

You could get say 3.5% when your term deposit winds up, but then you have to find another term deposit, by which time interest rates might be 2.5%.

However the bond fund you bought into at say $1, is now worth $1.50.

While bonds are seen as relatively lower risk assets, Martin points out the bond market is bigger than the sharemarket globally and more fortunes and have been made and probably lost in the bond market.

How does one buy bonds?

Martin says it’s easier for smaller time investors to invest in a bond fund rather than try to use a broker to buy bonds direct from the issuer.  

If their fees aren’t too different, Martin would opt for an actively managed fund over a passively managed or index tracking one.

To get an idea of what New Zealand bonds are on offer, see this page has put together. Also see this glossary of terms if you need a hand deciphering the language in any product disclosure statements you read when doing your research.

As for the cash part of the equation – I was worried Hamish’s bank balance was looking a too low relative to the amount he’d invested in shares.

Martin says the rule of thumb is one should keep at least the equivalent of between three and six months of your net income in cash.

He suggests using a risk calculator as a starting point, like this one on the Sorted website to get an idea of what your risk profile is and how you should allocate the assets in your investment portfolio accordingly.

Remember, your risk profile may look different to Hamish’s, so a 10% bond allocation as suggested by Martin, may not be best for you.

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