Why is diversification important?
One of the most important aspects of successful investment is diversification. This can be simply expressed as ‘don’t put all your eggs in one basket’.
Diversifying investments across a number of different assets is important because it may help to reduce the risks of investing. By risk we mean both that of losing money and that of experiencing volatile returns (extremes in the levels of return over time, in other words a ‘bumpy ride’).
Diversification may help to mitigate risk because not all assets react to the same conditions in the same way. For example if the weather in a year is better than expected we would expect an ice cream manufacturer to sell more ice cream but an umbrella seller to sell less umbrellas – and of course the opposite would be true in a year with poor weather. In more technical terms, the likely returns from these two companies are said to be uncorrelated.
This very simple analysis can be used to create portfolios that begin to manage risk, as investing in both the ice cream manufacturer and the umbrella seller together should cancel out some of the fluctuations from each business.
This idea of investing savings in more than one company is well established which is why most members of defined contribution schemes invest in pooled funds which have investments in many different companies, for example a UK equity pooled fund.
How does this affect my pension savings?
Most defined contribution pension schemes use exactly the same concept to reduce the risks associated with investing in a single stock market (for example the UK stock market).
This is most commonly done by investing pension savings into funds that mix overseas stock markets with the UK stock market.
Historically the returns from a stock market have been primarily dependent upon the underlying economy of the country they represent. Consequently they have offered diversification benefits to each other, similar to those we saw from our ice cream and umbrella seller example.
As the world has entered a greater period of financial harmonisation brought about by globalisation the diversifying benefits of investing in overseas stock markets have been substantially reduced. In fact we now find ourselves at a time where the major stock markets of the world react in a similar manner to events.
What can I do about this?
One solution to this changing behaviour of world stock markets is to recognise that they are increasingly likely to move in the same direction and then simply accept the consequences. These consequences are that the good long-term growth that investing in equities can generate comes with a bumpy ride; that there may be relatively long periods where equity markets deliver negative returns or fail to keep up with inflation.
An alternative is to find other types of investments that may generate similar long-term returns as equities whilst reacting differently to certain events. A good example of such an asset class is commodities (for example metals).
If interest rates in the UK rise, then after paying household bills like mortgages, people will have less money to spend on other things. Consequently, if investors expect interest rates to rise, we might expect demand for company shares to fall, as the profitability of these companies depends in large part on consumer demand. This could then result in falling equity markets.
In these circumstances demand for other ‘safer’ assets may increase. One such asset is gold, as investors often see gold as a way of protecting their investment in times of market turmoil. This may cause gold prices to rise. Therefore, we would expect a portfolio containing equities and gold to perform better than a pure equity portfolio if the outlook is for interest rates to rise. This is because the gains from the gold assets would be expected to partially compensate for the losses from the equities.
Gold is just one example of the types of things found in a commodities fund. Other commodities, such as energy, agriculture and other metals react in different ways from equities as well. Therefore, investing in a portfolio of equities and commodities can lead to a more diversified portfolio than investing in equities alone.
What are these diversifiers?
When we refer to asset classes that diversify the risks associated with the equity market we could include:
|Commodities||Energy, metals and agriculture|
|Emerging Market Debt||Bonds issued by the governments of developing countries (e.g. in Asia, Latin America)|
|Emerging Market Equity||Company shares listed on the stock markets of developing countries|
|Global High Yield Bonds||Bonds issued by companies and other organisations that have a lower credit rating|
|Hedge Funds||Funds which can use a variety of strategies in order to achieve an absolute positive return in any given market cycle|
|Property||UK and global property (offices, industrial and retail)|
|Private Equity||Shares in companies that are not listed on a recognised exchange|
Each of these asset classes has its own individual risks and so can be risky in isolation, as with equities. However, it is the practise of spreading risk exposures across a variety of asset classes, or diversified growth investing, that may lead to a reduction in overall risk or volatility.
The key point
A sensible long-term investment strategy may be to invest in a range of different asset classes and not overreact if one particular market falls. By placing money in a number of different asset classes the good returns you may receive from one investment over a certain time period may help offset the poor performance of another.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested