It’s easy to forget that less than six months ago most global equity markets were reaching record high levels, with US equities leading the way. Market volatility was also relatively benign; any sell offs we experienced were relatively shallow, followed by a swift recovery.
It’s at times like these when our clients begin to ask ‘why do you not hold more in equities?’ or ‘why are you still investing in bonds when there is no value?’
The answer is a simple one – diversification. The celebrated economist and Nobel Prize winner Harry Markowitz is said to have declared that ‘diversification is the only ”free lunch” in investing.’ If our aim was to simply provide the potential for the greatest level of return then, of course, our portfolios would be almost fully invested in equities, most likely from two or three markets. Such an allocation would, however, also leave the portfolios vulnerable to the potential of the greatest level of loss. We are acutely aware that our clients have varying appetites for risk and could feel very uncomfortable to see the capital values of their portfolios oscillate around wildly.
The key is not putting all of your eggs into one basket; it’s about being well diversified across asset classes, geographies and underlying investment managers. Diversification is one of 1825’s core investment beliefs when creating financial plans for our clients.
Diversification may mean that we are giving away some of the potential upside but it also means we should benefit from the greater reduction in volatility and risk.
Diversification in actionThe table below from JP Morgan highlights the perils of trying to predict which asset class will provide the best level of return:
The white 'Portfolio' tiles represent the performance of a balanced portfolio of various asset classes compared to the performance of the underlying constituents.
As we can see, the best performing asset class seldom retains that position in consecutive years, whilst the best performing can quickly become the worst performing and vice-versa. This highlights how hard it is to predict the best performing asset classes from one year to the next.
The balanced portfolio, however, has managed to consistently provide returns that are above the average level. The two columns furthest right represent the annualised returns for each asset class since 2008 and also the level of volatility each has experienced. The balanced portfolio appears in the upper half of the table for annual returns whilst at the lower end of the table for volatility. This reinforces 1825’s view that diversification, whilst not providing the highest returns, provides a more favourable risk/return journey for our clients.
Minimise capital losses
In these unsettling times that we currently find ourselves, we have to accept that there are going to be capital losses. The key is minimising these losses through a robust investment process and having a broadly diverse asset allocation. Consider, for example, a portfolio which falls by 50%. In order to recover those losses, it would need to rebound by 100%. Whereas, if it had fallen by 25%, it would only need to grow by 33% to recover those losses.
Our approach may mean that we do not fully capture big market returns during rallies, as this would require taking on more risk to do so. However, we believe that having portfolios which can provide positive returns in growth markets whilst helping limit the downside during market falls, are better suited to supporting our clients in achieving their financial planning goals.
Although it’s never easy living through times such as these, where portfolio values continually fluctuate, it’s important to continue having faith in the future and that markets and society will recover in time.
If you have any queries regarding this article, or your portfolio, please contact your Financial Planner.
Past performance is not a reliable guide to the future.
The information in this blog or any response to comments should not be regarded as financial advice. If you are unsure of any of the terminology used you should seek financial advice. Remember that the value of investments can go down as well as up, and could be worth less than what was paid in. The information is based on our understanding in May 2020.