Luck of the Irish

April 2011, The Profit

Understanding the right way to invest often starts with reviewing bad investment decisions however the lessons will be less painful if we learn from the mistakes and experiences of others.

Recent events in Europe provide case studies on what can go wrong when a wealth-building strategy is built on too much debt, too little diversification and too little awareness of risk.

For whatever reasons, Ireland became heavily dependent on several industries –construction and banking.  In a report prepared by the International Monetary Fund (IMF), they described the cause of these imbalances as “rapid credit growth, inflated property prices and high wage and price levels”.

Although an economy is obviously far more complex than any individual’s situation, there are still lessons that individuals can learn if they fail to spread their wealth-building strategies across different asset classes and don’t diversify within those asset classes.

Diversification reduces your risk by making you less susceptible to idiosyncrasies that are related to one sector, one company or one asset class and you can do this without significantly compromising your expected return.

Another lesson from Ireland is not to base your investment strategy only on what happens during the good times or the bad times.

Real interest rates in Ireland were very low before the Global Financial Crisis which encouraged people to borrow more debt. That debt now has to be repaid in an environment of falling prices, higher real interest rates and slower growth. The problem was too much focus on return and not enough focus on risk.

A better approach is to have a realistic, measured and long-term approach to risk. This means that during rising markets you don’t take on more risk than you originally intended and during falling markets you don’t become more risk averse than you first planned.

A third lesson is the importance of liquidity - being able to quickly turn your investments back into cash if you need to.

Ireland’s banks got into trouble because their loan portfolios were dominated by speculative property ventures. When the crisis hit, their recourse to short-term funding dried up and they were unable to call in loans because of the illiquid nature of the assets.

For individuals, the lesson is that there is value in having a portfolio with sufficient liquidity. That means publicly traded equity and fixed income securities that can be turned into cash if needed.

So Ireland has lessons that we can all learn from:
 

• Holding concentrated portfolios exposes you to risks you don’t need to take. Diversification is the answer, both across and within asset classes.
• Basing your strategy only on the good times means you can end up taking more risk than you intended. Conversely, grounding your strategy only on the bad times means you can miss real opportunities. The answer is to have a balanced approach to risk and return.
• Staking everything on illiquid assets can leave you high and dry when you need quick access to cash, so keep a proportion of your portfolio in liquid investments.

These strategic decisions should ultimately be made in consultation with your financial adviser – one who understands your tolerance for risk, personal situation and long term goals.

Don’t just rely on the luck of the Irish!