The importance of diversification

The importance of diversification
  • Financial planning
  • 3 minute read

To many investors it may have felt as though all asset classes suffered in the recent market turmoil. However, in most cases, a well-diversified portfolio would have proved more resilient. Lucy Katzarova, investment manager at Close Brothers Asset Management, explains the key role diversification plays in protecting clients’ portfolios.

Spreading the risk

There are two types of risk we need to consider – systematic risk, also known as market risk, which we can’t control (the downturn caused by COVID-19, is an example); and then there’s unsystematic risk, the risk of each individual investment. Unsystematic risk can be offset by investing in a number of holdings which perform differently during varying market conditions.

At Close Brothers, we manage diversified, multi-asset class, bespoke portfolios and we start by assessing our client’s risk appetite. This helps us determine how much of each asset class the client can be exposed to. We always advise clients not to put all their eggs in one basket and explain how we can help manage risk by spreading investments across different asset types, geographies and sectors.

Diversification across asset classes

The correlation between asset classes can change over time, but shares and bonds are typically uncorrelated – even with interest rates now at historical lows. This means that when one asset class goes up, the other goes down and vice versa.

Further diversification can be achieved by holding cash, gilts and alternative investments. These have helped us to reduce recent market volatility and contribute to additional sources of return for our clients.

Let’s say a client has a ‘balanced’ risk profile – they are not willing to take on higher risk but have a longer time horizon to remain invested. In a typical balanced portfolio, we could have c65% in shares (UK, European, US, Asian, Emerging Markets and Japanese shares); c19% in bonds; and, given the recent market storm, we’d also have c9.5% in alternatives and c6.5% in cash. These allocations are adjusted when our long term view of the markets change – one of the benefits of active management.

Alternative investments and absolute return funds

What do we mean by alternative investments? These include private equity, property and infrastructure trusts, which can provide useful income streams. Commodities such as oil and gold can also be used as diversifiers. Gold, which is seen as a ‘safe haven’, has held its value during recent market lows. In a balanced portfolio, we could have gold exposure of around 2% to 3%, but if you require income gold won’t pay any. The price of oil, on the other hand, has been extremely volatile and we’ve seen the price falling below $0 for the first time in history.

Absolute return funds aim to deliver returns in both a rising and falling market. These tend to perform differently from shares and bonds. For example, a ‘market neutral’ strategy invests so that the assets are not correlated to the general market. Some funds have performed well in this environment and have delivered positive returns. The difficulty is that you’ve got to pick the right funds.

Diversifying across geographies, sectors and counterparties

Within asset classes, we also diversify by different regions and sectors using individual stocks, unit trusts, investment trusts and exchange-traded funds (ETFs).

In a typical balanced portfolio, we may hold c25% in UK equities and within that we have a number of individual holdings and pooled vehicles. The segregated UK equity portfolio could consist of 20 to 30 stocks in a number of different sectors, such as healthcare, industrials, financials, materials, technology and consumer discretionaries and staples. We also may have exposure to funds investing in smaller and medium-sized companies, which could have 50 to 100 holdings, given their riskier nature.

When selecting specific funds, we ensure we diversify counterparty risk by carefully selecting providers. We have access to many funds and institutional share classes that are only available to professional investors.

The danger of over-diversification

Investors also need to be careful not to over-diversify. This can have a negative impact on portfolio performance; if the positions in each stock are so small that very little of the performance is captured and the portfolio underperforms the benchmark.

As the COVID-19 market sell-off has highlighted, diversification is essential for portfolios to remain resilient and continue to provide risk-adjusted returns for investors. If you are unsure as to whether your investments are sufficiently diversified to meet your requirements, it may be worth seeking help from a professional investment manager.

This article was first published in The Week and MoneyWeek, May 2020.

Your capital is at risk. Investments can go down as well as up. Past performance is not a reliable indicator of future returns.

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