April 2008
As investment markets continue to look
turbulent for the foreseeable future and investors grow more risk
averse, it is becoming increasingly challenging to find a balance
between risk and returns. The traditional heavy reliance on
equities could be a dependable and winning strategy during recent
bullish times, but is now a much more risky option. Success
in these more uncertain markets is increasingly dependent on the
ability to manage risk.
Diversification has always been a golden rule
for any sensible investor, but is now of even greater relevance. As
the importance of controlling risk has become a prime concern for
investment managers, diversified investment strategies have been
developed to achieve more consistent performance.
Many investment managers take a diversified
approach by constructing a portfolio comprising a wide range of
different asset types, such as: cash, bonds, property, equities and
alternative investments. In order to achieve an agreed level of
performance with minimal risk, the assets should ideally be chosen
to complement each other in terms of their lack of correlation in
market conditions. This approach works because investments do not
all respond in the same way to changes in economic conditions. In
theory, when one asset type is falling in value you can rely on
another to rise. In this way, diversification reduces risk by
minimising the impact of a negative performance of any one asset
type on the overall performance of the portfolio and therefore
reducing the inherent volatility of returns.
The efficient use of different asset types
can also offer additional advantages over a traditional equity
investment approach; these include wider opportunities from a
greater range of investment market conditions, scope to benefit
from the market upside and protect against the downside, and
potential reductions in overall costs. In addition, research over
the past thirty years has established that the determination of
asset allocation is the main driver and contributor to overall
investment gains.
The asset allocation process aims to
maintain the best performing asset classes based on the risk and
return expectations of the investor and the prevailing market
conditions. The use of asset allocation can also offer the
investor an opportunity to gain exposure to less traditional asset
classes, such as hedge funds, commodities and emerging markets.
The key is to manage the delicate balance
between risk and reward. Shrewd investors recognise that it is
necessary to take some risk to achieve a reward so it is essential
for an investment manager to ascertain their client’s individual
attitude to risk before advising them. An investor who cannot
contemplate losing any capital, or who is looking for a short term
investment, would be best advised to go for cash based products,
such as high interest savings accounts, capital protected products
or certain bonds. A heavily cash-based portfolio may not lose
money, but this benefit should always be weighed up against the
lost-opportunity cost of such a strategy. By investing heavily in
cash an investor may not be able to take advantage of any
developments or growth in other markets. Those investors who
are prepared to take a long term outlook, or a greater risk with a
view to potentially greater return, can find good value in certain
markets although should expect some turbulence in values.
One characteristic of the current credit
crunch is that diversification is becoming increasingly difficult
to find. With a slowing economy and unsettled markets, many
previously uncorrelated asset classes are now moving in the same
direction. However, by relying on the expertise of a discretionary
manager, an investor can access alternative asset classes such as
commodities and emerging markets, which are less correlated to the
more traditional equity and bond markets.
There is still a school of thought that
believes you need to concentrate your investments to make
exceptional returns, but this speculative strategy of putting all
your eggs in one basket entails a very high level of risk,
particularly in these uncertain times. Ultimately, the objective of
most investors is to achieve optimum return for the amount of risk
they are prepared to take and a well-diversified portfolio can
provide this.