In recent years, many Australian investors have responded to global uncertainty by focusing on local assets. They often have Australia-biased portfolios, which are a mix of Australian property, shares and bank term deposits. While these assets may seem far removed and insulated from the troubles of the global economy, their holders may in fact be significantly increasing their investment risk.
The risk of a more concentrated share market
The structure of the Australian share market has changed considerably in recent years. The resources sector is now a large part of the market as this sector has had a decade of very strong performance due to the mining boom. The sector is currently 25 per cent of the Australian market – double what it was in March 2000.
Australia’s share market is increasingly influenced by China’s economy. A prolonged downturn in the Chinese economy is an extreme scenario, but it’s certainly possible. If this happened, it would have painful consequences for the resources sector and the whole Australian share market.
For retirees, the concentrated structure of our share market may now also be out of line with their needs. Retirees need predictable income streams to maintain their lifestyle and insulate against the effect of future inflation.
For them, focusing on shares with predictable earnings and less volatility may be appropriate – and these features aren’t typical of resources companies.
The danger of common factor risks
The greater dependence of the Australian economy on China also means there is a common factor risk for many Australian investments. This is a theme or event that could affect a range of investments. A seemingly well diversified Australia-biased portfolio of shares, property, cash and hybrids has a common factor thread as it’s exposed to the likely negative effects of a prolonged slump in China.
The most obvious impact of a sustained Chinese downturn would probably be a sharp slump in the Australian mining sector. However, it could also result in a tougher profit environment for companies in other sectors, which could impact the share market more broadly.
In this scenario, a likely increase in Australian unemployment would also have an adverse effect on the housing market, perhaps leading to lower housing prices and rental incomes. As residential property is a big part of many Australians’ assets, this could negatively impact their wealth.
If a prolonged Chinese slump led to a sharp downturn in our economy, interest rates and bank deposit rates in Australia would also fall.
Diversification can help manage portfolio risk
These risks mean investors need to look beyond Australia for diversification opportunities. For example, including international shares in an Australia-only portfolio can improve its risk diversification because many offshore markets have less exposure to the resources and financial sectors.
Diversifying into international currency could also reduce portfolio risk in circumstances when the Australian dollar weakens, which is likely in a prolonged Chinese slump.
For Australian investors, the best guard against the uncertain global environment is to fully understand the nature of the risks in their portfolios and then include genuinely diversified investments.
Michael Karagianis is a senior investment strategist at MLC