Diversification is a common term in investment circles, but what does it mean, how do we implement it, and why is it important? A well-diversified portfolio can be the difference between weathering the storm in a financial crisis, or sustaining irrecoverable losses.
What is Diversification?
In certain market conditions, the various asset classes behave in different ways. Some benefit from the prevailing economic climate and will rise in value, so investors are better off. Other asset types may be negatively affected, and will lose money.
A diversified portfolio holds many different types of asset, so that when one falls, others should rise and offset the loss.
It is very difficult to predict world events and the impact they will have on financial markets. While it is common knowledge that shares will generally lose value in a recession, we cannot always know when the recession will arrive, which areas will be hit first or hardest, or when asset values have reached their lowest point, meaning that a recovery is on the way.
A diversified portfolio is best placed to deal with whatever market turmoil comes along. While we cannot predict how each individual share will behave, we can predict how the different asset types work together. This type of portfolio may not achieve the heady returns of a specialised tech fund, but it will also avoid heavy losses in most situations.
The Main Asset Classes
There are four main asset classes, which all behave in different ways depending on where we are in the economic cycle:
Cash
Cash is a stable asset, meaning that the value does not fluctuate. Historically, higher interest rates have meant that cash could be considered an investment in its own right. This has not been the case for several years. Interest rates are low, and inflation has been averaging 2.5% – 3.5% over the last ten years, though more recently that hasn’t been the case.
This means that a cash deposit is unlikely to hold its value in real terms. The main use of cash within a portfolio is to avoid any chance of loss, for example on money that will be required in the shorter term.
Bonds
A bond, or fixed interest security, is a loan to a company or government. Investors receive interest on their loan, and the higher the risk, the higher the interest rate.
This is complicated by the fact that bonds are bought and sold, both directly and within funds. While the interest rate is fixed, the market price of the investment will fluctuate with supply and demand.
Bonds carry more risk than cash, but are more likely to retain their real value over the long term. Conversely, they are less volatile than equities, but do not have the same growth potential. Bonds are often used as a diversifier against equities, as they rarely move in the same direction.
Property
Property is an asset class than most people understand, as a solid, bricks and mortar investment lies behind the valuation. However, property funds are subject to the same ‘supply and demand’ fluctuations as equities, and the share price does not always reflect the asset value.
In terms of growth potential, property sits somewhere between bonds and equities. Property benefits both from capital growth and an income yield in the form of rental. It is another diversifier against equities, although in some cases the two asset classes do move in the same direction.
In most conditions, the value of a property fund will be more stable than a share portfolio. Property does have additional risks related to liquidity – if too many investors request withdrawals, some of the underlying property needs to be sold. This can either lead to delays or an accelerating drop in value, as more assets are sold to meet demand.
Equities
In buying equities, you purchase a share of a company and are entitled to a proportion of the profits (dividends). The value of the share will fluctuate in line with the company’s fortunes, as well as investor opinion. Again, supply and demand is at work – the share price is not always a true reflection of the company’s value.
In general, equity prices have risen more quickly than other asset classes. This is compounded if dividends are re-invested by buying more shares. While equities provide the highest growth potential, they are also more volatile, and may lose money in the short term.
It is important to invest across all of the asset classes to gain the benefits of each, while mitigating the risks.
Diversifying Within Asset Classes
Diversification doesn’t stop there. A client’s risk profile may indicate that 60% of their portfolio should be invested in shares, but it would not be sensible to hold this amount in single company, or even in a single country.
True diversification means seeking variations within each asset class. This can involve investing in a range of geographical areas, in different industry sectors, or in varying sized companies. It may also mean deeper investigation into the business type of each company to avoid too much correlation.
Lessons from History
When a type of asset appears to be performing well, it can be tempting to put more money in, even to the extent of excluding other assets. This is a short-term tactic, based on false optimism. The ‘tech bubble’ of the early 2000s was an extreme example of this. Because of the intense demand for this relatively new sector, share prices became artificially inflated and not a true reflection of the underlying companies. The bubble popped in spectacular fashion, with many investors suffering heavy losses. A diversified portfolio, while not completely immune, would not be impacted to the same extent.
The 2008 financial crisis was unusual, in that all asset classes were negatively impacted. But diversified portfolios were well positioned to recover their value, with the temporary volatility becoming a ‘blip’ on an otherwise upward trajectory.
What Does a Well-Diversified Portfolio Look Like?
A well-diversified portfolio will not only hold the four main asset classes, but will invest across the world and in various industry sectors. It will invest in small and large companies, in mature economies and emerging markets.
When things are going well, the portfolio will make modest gains. While it may lose money during volatile periods, it will not be as exposed as a more homogenous basket of investments. The goal is a steady, long-term return.
While this may sound complicated, a diversified portfolio is easily achievable, whether you are starting to invest for the first time or you require a more sophisticated proposition.
