Why it pays to spread your savings

Diversification is a winning investment strategy — but how much is enough?

Q: I read your articles weekly and see diversification within a portfolio of shares mentioned often.

I can understand and see the point of diversification and it makes a lot of sense to me. Where I become unsure is where does an index fund fit in this definition?

Let’s say I want a portfolio of New Zealand shares (ignoring the fact that I have already limited the diversification of the portfolio by investing only in New Zealand). If I buy (say) the Smartshares NZ Top

50 ETF (exchange traded fund) and only this ETF, does this holding constitute a portfolio of New Zealand shares and is it considered diversified?

A: Let’s start by explaining share diversification.

● If you own shares in just one company, a typical range of returns on that investment might be from minus 40 per cent to 60 per cent. The average of those two returns is 10 per cent.

● If you own shares in two companies, the range of returns might be from minus 30 per cent to

50 per cent. The range is smaller because, if one share falls or rises a lot, chances are that the other one won’t move as dramatically, watering things down. Perhaps it’s in a different industry that is less affected by a changed environment. But the average return is still 10 per cent.

● If you own shares in 50 companies, the range might be from minus 10 per cent to 30 per cent. With many shares, there’s a lot more watering down going on. But the average return is unchanged, at

10 per cent.

In other words, if you diversify — by owning lots of shares — you’re much less likely to get really good returns or really bad returns. And most people are happy with that trade-off. We hate big losses.

Now let’s introduce index funds — or any other share funds actually. They invest money from many people in a whole lot of different shares. Some funds might hold only about 30 companies, while other big international funds hold thousands. They are all pretty well diversified, but some are better than others.

A fund like the Smartshares NZ50 index fund invests in the biggest New Zealand shares, so it covers a pretty wide range of industries. But it doesn’t include smaller companies, which are more likely to either grow fast or go belly-up. They are higher risk, and on average bring in higher returns over time.

That fund also confines itself to one country, as you point out. One advantage of investing in New Zealand companies is that you get credit for tax they have already paid, through dividend imputation. But it’s also great to have most of your savings invested internationally. It’s the same story: when one country is doing badly, there’s a good chance other countries will be doing well, to water down losses.

The simplest way to invest internationally is through a New Zealand-run fund that buys shares around the world. You don’t get caught up in tax issues and so on. Smartshares has a Total World ETF, and other providers have similar funds. They give excellent diversification.

Saving v the mortgage

Q: I read the piece last week about the age-old question of saving versus paying down a mortgage.

One area of possible clarification. You rightly note that paying down a 3.99 per cent mortgage is like earning 3.99 per cent on an investment. What may be worth adding is that it is on an investment after tax and fees. So in reality, paying down such a mortgage is like receiving a gross return of around 6.5 per cent (assuming fees of 1 per cent and 28 per cent PIR).

As you say, this is risk-free — so paying off the mortgage is probably the best risk-adjusted return available.

It’s still likely that over the long term a good diversified portfolio of shares will provide a higher return — but it’ll be a bumpier ride!

A: Good point. Whenever we think about any investment, we need to take fees and tax into account.

Trimming your debt

Q: I noted your advice last week re paying down lump sums on fixed interest mortgages and that a fee would likely be charged. A lot of people are unaware you can pay up to a 5 per cent lump sum every 12 months on a fixed-term mortgage without penalty.

A: Another good point. The rules on this vary with the lender. But most lenders permit some extra repayments off a fixed mortgage without penalty. It’s worth asking.

Talk to the bank

Q: Just read your article about a reader with a lump sum deciding to pay down a mortgage versus doing something else with it, and the fees associated with breaking a fixed term. I did that, and it cost me a grand total of $10 to break the term, pay a lump sum, then refix at a new rate. So it’s worth a chat with the bank before being put off the idea completely.

My one-year term was due to end in July, but by April I got a little nervous with where rates were headed. I’m glad I did, because only a fortnight later they went up again. Fortunately, I had been making more than the minimum repayments so the hit to the wallet is the same, just the proportion of interest to principal has changed (such is life).

Talked to the bank and asked if they could do anything — not only did I get to refix at a lower-thanadvertised rate but was also told the fee to break the term is actually lower when mortgage rates are going up.

Just in case readers are worried that the fee to break a term is going to be hellishly exorbitant. :)

A: You’re quite right that penalties for repaying a fixed mortgage early are much lower when interest rates are rising, as they are now.

The bank is happy if you pay back a loan on which they are getting, say,

2 per cent, so they can lend the money to somebody else at 5 per cent. Who wouldn’t be!

When interest rates are falling, though, a lender is much more reluctant to end a loan paying them a higher-than-current rate. That’s when the penalty can be huge.

A couple of other comments:

● It’s great that you had been making higher than minimum payments. That reduces total interest paid and, as you say, gives you a buffer against rising rates.

● You’ve shown, once again, that talking to your mortgage lender can often get you a better deal. Well done.

Mary Holm, ONZM, is a freelance

● journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.