Diversify your investment
As capital markets continue to look turbulent for the
foreseeable future and investors grow more risk averse, it is
increasingly challenging to find a balance between risk and
returns. The traditional heavy reliance on equities has been a
dependable and winning strategy during recent bullish times, but it
currently is 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 it 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 from any one asset
type on the overall performance of the portfolio and therefore
reduces the volatility of returns.
The efficient use of different asset types
offers additional advantages over a traditional equity based
investment style; these include access to wider opportunities from
a greater range of investment markets, scope to benefit from the
market upside and protect against the downside, and potential
reductions in overall costs. In addition, academic research over
the past thirty years has established that asset allocation is the
main driver and contributor to overall investment gains.
The asset allocation process aims to
provide exposure to the best performing asset classes based on the
risk and return expectations of the investor and the prevailing
market conditions. The use of multi-asset class allocation can also
offer the investor an opportunity to gain exposure to less
traditional asset classes, such as hedge funds, commodities and
private equity.
Shrewd investors recognise that it is
necessary to take some risk to achieve a return. It is therefore
essential for an investment manager to ascertain their client’s
attitude to asset price volatility and determine their risk budget
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 and asset classes. Those investors who are prepared to take
a long term outlook, or a greater risk with a view to potentially
greater return, have a broader investment universe to explore.
One characteristic of the current credit
crunch is that diversification is becoming increasingly difficult
to find. With a slowing global economy leading to volatile markets,
many previously uncorrelated asset classes are now moving in the
same direction.
There remains a school of thought that
believes an investor needs to concentrate their investments to
capture returns, but this speculative strategy of putting all their
eggs in one basket results in 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 multi-asset class
portfolio has historically been well placed to provide this.