You need Rational Diversification and Time
by Bill Blevins, Financial Correspondent

If I could grant investors one wish I am sure they would all choose to be able to foresee the future. If this were possible we could choose investment opportunities that we knew were going to do well and avoid those about to go through a poor period. We’d get all the rewards without any of the risk. Unfortunately I cannot offer this… but I can offer some sound advice on an effective way of controlling risk, a method which also significantly increases the likelihood that you will achieve above average returns over the longer term.

I am talking about “true” diversification, which means that your portfolio will include different asset classes, investment styles and fund managers. Your investments will be structured to anticipate risks and minimise the damage that can result from one investment hitting a rough patch. It also takes advantage of new opportunities and allows you to benefit from upturns in certain markets, ones you may otherwise have chosen to stay clear of.

This is the mix of asset classes (equities, bonds, cash, property etc) that you hold in your portfolio and is the key to meeting your investment objectives. It works to your advantage as the risk of the combination of asset classes is less than the average risk of the individual components, thus lowering volatility. Investing almost always requires you to take on some risk and it is important to find the risk/return balance that works for you. Too little return and you won’t reach your financial goals; too much risk and you won’t sleep at night!

The solution is to get the asset mix right. To do this you need to consider what returns you expect to receive; what sort of risks you are willing to take; how much volatility you can bear and the length of time you can stay invested. Different asset classes have different risk and return characteristics and they should be combined in a way that meets your objectives and need for stability. As a result your portfolio is more likely to deliver what you expect.

Once you have established your asset allocation you need to avoid the temptation of changing it in reaction to market conditions. This is the same as trying to time the market, which is unwise. It should, however, be reviewed if your personal circumstances change.

A recent article in the FT magazine Money Management summarised the benefits of asset allocation:

“In the world of professional and institutional investment, it is well known that the real opportunity to achieve superior returns lies not in scrambling to outperform the market with frenetic stock picking, but rather adhering to efficient and disciplined asset allocation over the long term.”

The same article concluded: “For an effective investment return, asset allocation is not an optional requirement, but an essential element in being able to successfully fulfil [your] expectations.”

Asset allocation is further refined by diversifying the equities in your portfolio across styles, geographical areas, industries and currencies.

Styles include growth; value; market oriented; small capitalisation and large capitalisation. Different economic and market conditions favour different styles, for example growth and value rarely perform well at the same time. As a general rule growth does well in the middle of bull markets and value in bear markets, however predicting when the cycles will start and end is virtually impossible.

Geographical spread is also important. Most investors prefer to stick with the familiar US and UK equity markets, but you should not be cut off from opportunities in the global market place. Different countries tend to experience differing levels of growth and cycles. Diversification across geographical markets can increase the number of available investment opportunities and give you access to regional performance differences.

Likewise, it is unusual for one industry to outperform consistently and it’s not easy to predict which ones will do well, and when. You should therefore include a spread of industries in your portfolio. Exposure to different currencies will also help diversify risk.

Any number of economic and other issues can affect fund performance and it’s impossible to foresee all eventualities. However with diversification you will have positioned your funds to capitalise on different future market environments by laying the groundwork to take advantage of almost any development.

Many investors tend to stop their diversification at this point, but there is a third layer which is an essential component of any sophisticated diversification strategy:

This investment process places assets in any one style with multiple management firms. Managers rarely outperform consistently and they all have their own styles which work better in some market conditions than in others. This could mean that your funds will suffer if they are managed by just a few managers, even if their past performance record was impressive when you chose them. The opportunity to have a large number of experienced managers looking after your funds is one everyone should consider.

Multi manager funds bring together the expertise of various asset management houses within one product. They aim to deliver consistent relative performance, whilst carefully balancing risk.

Multi management, in fact, offers an all in one investment solution that combines diversification, active management and risk control in a simple, tax efficient, cost savings vehicle. The wide range of diversification it offers serves to reduce the risks associated with one market or one fund manager and increases the opportunity to benefit from upturns in different markets around the world. It’s no wonder that, according to a recent Cerulli report, it has grown 16% a year over the past three years, whilst the rest of the mutual fund market has decreased.

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