How to diversify in volatile times
This may appear to be a quote from a financial publication but it’s actually taken from the Bible, the book of Ecclesiastes. A more common phrase is simply “don’t put all your eggs in one basket”. But why is diversification so important?
It has been at the heart of portfolio construction for many years, as a technique used to reduce investment risk. When creating a diversified portfolio, you are looking to hold a range of investments which will potentially perform differently in varying market conditions.
The aim is you are not 100 per cent exposed to the worst performing asset at one particular time, which also means you won’t be 100 per cent exposed to the strongest performing asset. By reducing exposure to the extremes, this hopefully narrows the range of possible return outcomes from your portfolio.
When building a diversified portfolio, the correlation between investments should be considered. A correlation of 1 between two investments indicates they will always move in the same direction. The closer the correlation is to zero the less likely the two investments will move in the same way. A correlation of minus one is when investments move perfectly in the opposite direction, i.e. whilst one is going up the other is going down. The latter however is more likely to be achieved by adopting hedging techniques.
Diversification can simply be achieved by investing in a fund rather than directly, such as in individual shares. As well as benefitting from the fund manager’s expertise, your capital is spread across a greater array of investments owing to the benefits of pooling your money with other investors.
Investing in different asset classes whose performances differ from one another also provides diversification. For example, within the Lowes Cautious Income portfolio exposure is taken to equities, fixed income and property. Each asset class has different return characteristics and performance should differ in various market and economic conditions.
However, you can still create diversification when investing in only one asset class. For example, investing in large, mid- and small cap stocks. This can provide an important level of diversification in terms of returns. To put this in perspective, over the last six months the FTSE 100 (large cap) has returned -11.23 per cent, the FTSE 250 (mid cap) —2.02 per cent and the FTSE Small Cap (ex investment trusts) 4.93 per cent.
We also allocate to fund managers who have a different style bias. Some managers are more value orientated, namely they identify stocks which have fallen out of favour with the market but in which they recognise strong turnaround potential. Others focus on growth companies, with strong earnings potential owing to their dominant market position. Further diversification in portfolios can be achieved through considering investment in overseas investment markets.
Volatile markets serve as a reminder of the importance of diversification. Over the last few years event risk has been high. We have seen the worst financial crisis of most people’s lifetimes, the European crisis, issues in China, Ukraine, Brazil, Greece and many more. Furthermore, crises such as these can arrive unannounced with the full impact unknown. Such events serve to remind us diversification of investments is important to increase your potential of achieving attractive relative returns in varying market conditions.
Paul Milburn is an investment analyst at Lowes Financial Management.