The saying “don’t put your eggs in one basket” should be every investor’s mantra. Anyone who has felt the pain of investing in a single stock or sector just before it crashed knows the danger of ignoring this advice all too well.
Diversification limits the risk that comes with single-asset exposure. By distributing an investor’s capital across various asset classes, an investor can limit portfolio volatility in relation to expected returns.
This reduces the likelihood of great loss because the negative performance of one asset class can be offset by the performance of another. An example is the use of U.K government bonds (known as gilts) in an equity-dominated portfolio. While bonds traditionally underperform equities in the long term, they often rally during periods of stress on stock markets as investors look for safe havens for their money. The impact on a multi-asset portfolio that has both asset classes is to help reduce overall portfolio volatility.
The first step to successful diversification is to understand individual circumstance.
“This is important because there isn’t a one-size-fits-all approach to diversification and asset allocation. Ideally, one’s investment portfolio should fit in well with the rest of their financial planning regime,” says Gavin Smith, Head of Africa at deVere Acuma.
A single 25-year old with no children, starting off their career has very different needs to a 40-year old who’s married with three children. Each investor also has their own personal attitude to how much risk (i.e. market volatility) they are willing to accept.
In his investment outlook, Tom Elliott, an international investment strategist at deVere Acuma, says financial history shows that a typical long-term balanced portfolio based with a 60/40 exposure to developed global equities and global investment grade bonds respectively offers good returns relative to risk.
“Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor,” says Elliott.
For many years, the ‘100 minus your age’ rule – similar to the strategy suggested by Elliott – was used to allocate equities and bonds in a portfolio. Using the rule, a 30-year old investor would allocate 70% of their portfolio to various equities and 30% would go to bonds.
Smith says this approach is too simplified because it ignores personal circumstance, investment objectives and risk tolerance – which play a role in crafting a suitable diversification strategy.
Different types of asset allocation
Smith says a well-diversified multi-asset portfolio, with a clear-cut strategy and focused outcomes, can yield pleasing results for long-term investors. He outlines the basics of two different approaches that investors can take, with a choice between active and passive approaches to investing:
A passive multi-asset fund attempts to mirror a benchmark. The fund manager may believe that it is impossible to add value by ‘betting’ (as they might see it) on certain stocks, or bonds. Instead, they will imitate the weighting of a stock or a bond that is already in the benchmark they are tracking. Most exchange traded funds (ETFs) are run on this principle. The result is a relatively cheap fund, since there is no need for research in order to find stocks and bonds to go overweight or underweight on, relative to the benchmark.
A passive strategy is sometimes thought most applicable to funds that focus on stock and bond markets with large, mature and transparent companies and borrowers, for which an individual fund manager may struggle to gain privileged price-sensitive information. The biggest risk for the fund manager is tracking error – can he or she buy and sell stock or bonds in similar quantities, for a similar price, as changes in their benchmark weighting require?
Because of trading costs, a passive fund will always slightly underperform its benchmark in terms of return. A passive fund rebalances constantly, making it a forced buyer, and seller, of stocks and bonds as their weighting in the benchmark changes. This means the fund can be following investment fashions blindly, which poses a risk in the event of the trend turning.
An active fund has a fund manager who attempts to beat the fund’s benchmark, through taking active bets against the fund’s benchmark with ‘overweight’ and ‘underweight’ positions. This means attempting to predict changes in share and bond prices. Active funds tend to cost more than passive because they employ teams of researchers to try to identify winning -and losing- stocks and bonds.
Active funds are generally considered more effective than passive funds when they focus on companies and bond issuers for whom information can be difficult to find. So investors in the small cap and emerging market asset classes may well prefer an active fund. An active fund manager may rebalance on a regular basis (perhaps quarterly), but is under no obligation to ‘re-set’ the stock and bond holdings to mirror the benchmark. This gives active fund managers a degree of flexibility that passive fund managers do not have, and means they do not have to be slaves of a particular investment fashion. However, freedom to deviate from benchmark can lead to underperformance as well as outperformance, a risk that a passive fund manager does not have.
While active may be the more costly option, an investor has to be careful not to discard the benefits of having an active manager, especially if there’s the risk they may not make the right passive investments for themselves. “You can always employ both in your investment strategy – think of it as another form of diversification”, says Smith.
It’s important that an investor understands their needs, adds Smith, pointing out that one should always be aware of the risk they’re willing to take on and the goal they’re trying to reach. “Don’t get caught up in hot debates and lose sight of your investment objectives,” he cautions investors.
About deVere Acuma
deVere Acuma is part of deVere Group. deVere is one of the world’s largest independent advisors of specialist global financial solutions to international, local mass affluent, and high-net-worth clients. It has a network of more than 70 offices across the world, over 80,000 clients and $12bn under advisement.