One thing it has done for me is to reinforce the positive effects of diversification. Unlike Malkiel I do not equate risk with volatility, but reducing volatility is a Good Thing provided it does not significantly increase risk or decrease return. My criteria for adding a new investment to my portfolio should therefore be:
- It must have a similar/better risk/return trade-off compared with my existing portfolio.
- It must not be strongly correlated with an existing investment.
At the moment many asset classes are moving in harness with one another due to the global shortage of liquidity, but this won't last forever.
My current portfolio (considering such things fairly broadly but excluding my pension fund) consists of:
- Residential property, one of, i.e. the house I live in.
- A negative net Sterling cash balance, i.e. cash + mortgage.
- A positive net US Dollar cash balance, coming due in January 2010.
- A share portfolio.
If my house is worth 100, the other components of my portfolio are roughly:
- Sterling balance of -40.
- US dollar balance of 20.
- Share portfolio of 15.
The share portfolio is clearly a relatively small component, but is likely to have superior returns, so I think it's fairly obvious that I should continue to buy shares. In a year or two I think a reasonable position would be: house 100 / sterling -50 / dollars 0 / investments 60.
I've been mulling over whether I should diversify into bonds and/or real estate. Clearly I'm heavily overweight in UK residential property, so any real estate investment will need to be sufficiently different to provide diversification benefits. Any any diversification needs to fulfill my criteria above.
I'm looking for an after-inflation return of approximately 6% over the long-term. The ishares International Property Yield ETF (IWDP) has a yield of 9.66%, although that is skewed by an abnormally high dividend payment almost a year ago. Stripping that out, the yield is about 6.3% - and commercial property has historically been a good inflation hedge. So the return on this is adequate. It will be correlated with shares and UK residential property to some extent, but the correlation should be less than 1.
The ishares £ corporate bond (SLXX) has a gross yield to redemption of 8.16%. With no defaults and inflation of 2%, that gives a real return of just over 6%... but I don't fancy predicting the rate of inflation given the current circumstances. Also, most of the holdings appear to be banking-related, which isn't necessarily the safest place to be.
I think for now I'll continue to monitor these two. I think IWDP is reasonable at its current price, and SLXX needs to be a little bit cheaper. But I probably won't be adding any new investments for a month or two.
Update:
In the last 5 days IWDP has shifted in price so it now has a yield of 10.97%, which I estimate to be about 7.3% adjusting for last year's freakish dividend. That's at a price of $11.18. However, I do have some concerns about some of the REITs that constitute this ETF.
Here are the top 5 holdings:
- Sun Hung Kai Properties, weighted at 5.1%. Hong Kong properties. Payout ratio of 0.5. Gearing 25%. Interest cover 7.5 times.
- Westfield Group, weighted at 5.1%. Australia, NZ, US, UK property. Payout ratio 1. Gearing 70%. Interest cover 3.5 times.
- Unibail-Rodamco, weighted at 3.6%. French. Payout ratio 0.9. Gearing 85%. Interest cover 7 times.
- Simon Property Group, weighted at 3.1%. US commercial property. Gearing 600%. Payout ratio 2.2 or 0.6 (depending on whether you look at net earnings or FFO). Interest cover 1.6 times.
- Vornado Realty Trust, weighted at 2.5%. US commercial property. Gearing 260%. Payout ratio 1.1 or 0.6. Interest cover 2.1 times.
The US REITS seem to be very heavily geared. By contrast, REITs from other countries have relatively modest gearing. I would not be surprised to see some of the more heavily geared REITs go down the pan - so I would need to take account of that before investing.
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