October 03, 2017

Using Technology to Diversify an Investment Portfolio

Opinion : David Kirk

A key to any successful investment portfolio and overall investment strategy over the long term is diversification. Whether the market is bullish or bearish, a widely diversified portfolio offers protection to the investor through the reduction of risk and an increase of consistency. Successful diversification can only come through investing in industries and particular companies that are not correlated with each other.

The correlation of stocks is a driving factor for investment choices. Statisticians and financial analysts model correlation to better understand possible movements in markets and the similarities and dissimilarities of specific stocks.

The measurement of correlation is called the correlation coefficient, and is quite simple: a correlation of +1.0 means two investments fluctuate in perfect similarity, if one goes up the other goes up with it. A correlation of -1.0 means that the compared stocks have a complete negative correlation, if one declines the other rises and vice versa, in perfect opposition. A correlation near zero describes an investment that has no similarities to its comparative asset and is therefore entirely disparate in movement.

These correlation options are then used to build a portfolio of investments that, ideally, has a correlation of zero, managing the risk of investment. The theory is named the ‘portfolio effect’.

Although the importance of diversification is widely-known throughout the investor community, many investors in Australia and New Zealand lean towards investing in the ASX100 Index to gain diversification of their portfolio. The ASX100 Index, although varying in industries, is weighed heavily toward the financial and materials sector, which make up almost 60% of the Index and accordingly provide very little protection through the portfolio effect.

Why is technology a smart investment?

It’s no secret that advances in technology and the growth of tech companies to global giants has provided great opportunities for investing across the world. Tech shows little sign of slowing down and is permeating nearly every industry in some way. The decentralisation of software - known as software as a service, or cloud based software - allows businesses to scale rapidly and cost effectively.

Information technology at the ‘expansion stage’ is a particularly interesting investment opportunity. Typical ‘expansion stage’ companies have $5-10m of revenue, are private and growing fast. These companies are not yet listed on the Australian stock exchange and their prospects are not linked at all to the fortunes of the companies in the major ASX Indices. This means they have very low correlation to the typical large companies on the ASX.

These smaller, fast growing information technology businesses are replacing older, out-dated moethods in the media, entertainment, travel, hotel, taxi, financial services and many other industries.

Investors can access previously inaccessible tech opportunities in private tech companies during the ripe growth stage by leveraging the insights, knowledge and experience of expansion stage information technology investors of Bailador Technology Investments (ASX:BTI).

Bailador provides investors with the opportunity to invest in a portfolio of 9 expansion stage tech companies. Together the 9 companies employ 1,050 people, have offices in 13 countries around the world and a combined revenue of $153 million which grew at 37% in the last financial year.

By investing in private companies the investment manager can get to know the management teams well before investing and gain a range of special protections such as investing in preference shares, anti-dilution and (after an agreed period of time) control of the timing of exits.