BLOG: Diversification – Selecting the right mix of assets
If all investment decisions were perfect, diversification would be redundant. We would simply put all of our money into the asset class that we knew was going to perform best. In reality, however, even the most shrewd investor cannot possibly get this correct every single time.
Equities had an exceptional year in 2013 and are widely predicted to see good gains again in 2014, as the global recovery has led to increased market optimism. However, geopolitical tension in some areas and slower-than-predicted growth in others has led to volatility in equity markets, whereas bond markets have shone brighter than expected so far this year. These short-term fluctuations highlight that the exact timing of market moves is ultimately unknown. Diversification, a cornerstone of modern portfolio theory, therefore has a distinct role to play: by holding a varied mix of assets an investor will, in theory, always have exposure to some winners – the good offsetting the bad – thereby spreading the overall risk.
A multi-asset investment approach offers the potential for ‘smoother’ long-term investment returns, regardless of the market conditions. However, simply holding a range of different assets does not necessarily ensure a diversified portfolio. If the asset classes held are highly correlated and react similarly to certain market conditions, the diversification impact is not only minimal, but the risk is potentially magnified. Assets within a truly diversified portfolio will therefore have low, or even inverse, performance correlation to optimise the balance between performance and risk. Studies have shown that a fund’s allocation to different assets – rather than the choice of securities within an asset class – has the largest impact on long-term performance. Selecting the right mix of assets, in the right proportions, should therefore form the key task of a multi-asset manager.
Another important distinction to make is that between real and nominal assets. Real assets, which should offer returns above inflation, include equities, inflation-linked bonds, real estate and, arguably, commodities. Nominal assets on the other hand, such as cash and ordinary bonds, face an erosion of value in inflationary environments. Given that most investors are looking to maintain, or increase, their long-term purchasing power, investment returns need to match, or exceed, the rate of inflation. In the current environment, equity yields are sufficiently high to provide a real source of income. Index-linked gilt yields are lower, but their RPI-linked income and redemption payments offer protection against any upward lurch in inflation, as seen in this month’s UK figures. Furthermore, as fixed income assets, their low correlation with equities can smooth volatility when held alongside each other in a portfolio.
Given the current market environment, the arguments for multi-asset diversification remain convincing, provided assets within a portfolio have low correlations and are truly diversified.
Richard Marwood manages the AXA Distribution Fund.