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Diversification is the key to successful investment
12:21pm Friday 18th November 2011 in Business
‘Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket”, or so goes the quote from Cervantes’ novel Don Quixote.
And almost 400 years later, the sentiment is as true today as it may have been back then.
The discipline of diversification, in a financial sense, is one of which investors are being increasingly reminded given the volatile nature of global investment markets over the past few years.
Furthermore, investors are now able to access a much wider range of asset classes than the traditional choice of equities (shares), fixed interest securities, property and cash.
Demand from increasingly savvy retail investors has seen the advent of commodities, private equity and other ‘alternative asset classes’ added to their armoury.
With the global economy seemingly teetering on the brink, the adage of having a balanced portfolio has never been as relevant.
And if we take a look back at how various asset classes have fared both before the global banking crisis in 2008 and the period afterwards, it’s all too clear that holding a balanced, diversified portfolio is a key factor in achieving your long term investment objectives.
No-one can predict which investment is going to produce the best returns year after year, but there are two things we can be fairly sure of; the best performing investment in one year can often turn out to be the worst performing investment the next year and, by spreading your money across a selection of asset types, countries and sectors, your investments stand a better chance of achieving more consistent returns.
During the global banking crisis of 2008, UK equities (measured by the FTSE All Share index) were at the bottom of the league table versus other investments, losing -30% over the calendar year.
Yet in 2009, as investors’ confidence buoyed on the back of a more stable economic environment, they led the way, reversing all those losses with a gain of 30% over the following 12 month period.
But is it just these so-called risk assets that suffer such extremes? Definitely not. If we take UK gilts a similar, yet opposite, pattern emerges. As investors sold off equities in 2008, the demand for, and consequently the price of gilts rose to record levels, making it the strongest performing asset class of the year, returning over 13% over the year.
Yet as those conditions flipped, gilts lost -1% over the next 12 months.
The message is clear: no single asset class performs consistently well.
The best way to avoid these boom-and-bust cycles is to make objective investment decisions – and this means that getting the balance right is vital. Sadly, too many investors realise they have poor asset allocation only when it is too late.
It is why prevention is better than cure.
Building a balanced portfolio is a question of managing risk versus return. Risk is not just about potential capital losses – you also have to consider the risk of inflation, for instance, and a reduction in income if circumstances go against you.
For example, the derisory rates on cash deposit accounts means that most people’s savings are failing to keep up with inflation.
Indeed, higher-rate taxpayers need to find an account paying 8.67 per cent to keep pace with rising prices.
Yet there are none that offer this rate, of course, all of which is why many savers are being forced to look farther afield to make the most of their money.
So the question is where do they look?
An investor’s attitude to risk is a key factor.
The sensible investor takes into account the amount of risk they are able to tolerate both emotionally and practically in terms of their individual needs. It is therefore vital to understand the different levels of risk inherent in various types of investments.
Different asset classes have different risk profiles.
Cash, gilts and corporate bonds are generally perceived as lower risk investments and, historically, have provided less volatile returns than other asset classes.
However, equities are considered to be further up the risk ladder but offer investors the potential for greater returns.
History demonstrates that investing in equities beats the returns of other assets, including cash, over the long term.
According to data from Barclays Capital, over the period since the end of 1899 equities have provided annualised real returns of 5.1% versus just 1.4% for gilts and 1.0% for cash.
Whilst the asset allocation for each investor’s portfolio will be dependent on their individual needs and objectives, what is clear is that relying on just one or two asset classes to consistently meet your income and/or capital growth needs is unlikely to be a successful strategy.
The uncertainty that is gripping global markets is likely to be here to stay, at least for the foreseeable future.
As the bailout discussions in Europe have shown, there is no quick or simple fix. But the same cannot be said for re-organising your investment portfolio and the discussions you might need to have with your financial adviser.
To receive a complimentary brochure covering Financial Planning, Pensions, Protection and Inheritance Tax Planning, contact Stephen Samuels of Samuels Financial on 0161 773 5777, email firstname.lastname@example.org or visit samuelsfinancial.co.uk