ABC of diversification
Diversification seems to be the most popular word in investment management. Like many concepts that are repeated ad nauseum, however, it is often hard to pin down exactly what it means in practice.
If one turns to that everyday oracle Wikipedia, you find a very general definition, terming it as ‘reducing risk by investing in a variety of assets’.
While not the world’s worst definition, it does tend to create more questions than it answers. What are these assets? Where should you find them? How do you access them? What about cost effectiveness?
Although these are not necessarily appropriate questions for an encyclopedia compiled by the general public, they are ones that financial advisers should be asking themselves.
What does ‘diversification’ actually mean? It is true that investing in a variety of assets does form part of the equation, but it is certainly not the entire answer.
When building portfolios, there is an increasing trend towards picking out the ‘best performers’ in terms of funds in each sector. However, this may not bear the results that advisers want.
What happens if the best past performers all turn out to be in UK equities? Or all centre around funds invested in small caps? While it is not advisable to start picking funds with woeful records in different sectors purely in the name of diversification, it is also not advisable to pick a portfolio that, on the surface, is fully spread out regionally but mainly relies on the ongoing success of small caps, for example.
Diversifying your managers
Getting variety for a client should not be limited to the assets themselves. Picking a diverse range of managers can also add value. Differences in styles of investing such as growth and value can actually be more relevant as different managers will seek protection from the falls in a variety of ways and, to this end, provide a measure of protection to the client.
It is also important to remember what most clients look for in their investments. A relevant illustration of this can be found in the research conducted by the Personal Accounts Delivery Authority (Pada), now known as the National Employment Savings Trust (Nest), among its target market.
Although it surveyed those on low-to-moderate incomes, the findings can be applied to the wider public as the government body found that attitudes to investing primarily centred around aversion to loss.
In other words, a portfolio can get the best returns in the world in a good market but, if in the down times, it loses money hand over fist, your clients are unlikely to be happy. Picture 2008 when the market fell 40 per cent – clients would have been happy to only gain 8 per cent in a good market if it meant restricting losses on the downside to 8 per cent.