Basic Concepts
The reason for diversifying investments is to limit the extent to which your money is at risk of huge swings in value, or making pathetic returns. The opposite of diversity is concentration and in the extreme the most concentrated portfolio would own only a single share or asset. Of course if you got lucky and the one investment you had selected rocketed in value, then you would benefit from the concentration.
If you are a Buy to Let landlord with just one house apart from the one you live in, then you have no diversity, except that the asset is another sort compared to, say investment funds, so you get some asset class diversification (there is more about asset classes in the Glossary and the member only articles) . If the economy goes into recession and the area where your rented property is located is hard hit, you may have no tenant and no prospect of selling, so you have what is at least temporarily a worthless asset. If you had owned 5 properties in different areas, then you might at least have some tenants still paying rent, but I would hope your 5 properties were not all in the same housing estate! A government minister was recently reported to have bought 7 flats in the same development as an investment. Junior doctors already think he is not too bright and I think I am bound to agree now.
When buying investment funds or shares, you would sensibly seek to put together a collection of assets that react differently in a given financial or economic situation. You would do this by selecting assets that are not ‘correlated’. That is a term that has a strict meaning in statistics, but is easily understood if you imagine a graph with 2 lines showing the value of two investments over a time period. If they are correlated, the lines will have the same shape, going up and down at the same places (even if by different amounts – that is the degree of correlation). If one goes up when the other goes down, then they are ‘negatively correlated’ and if they were to be perfectly negatively correlated and the only 2 investments you own, you would never make or lose a penny! If the lines seem to be totally disconnected and there is no pattern, then there is no obvious correlation (but one can likely still be calculated statistically).
A bit of theory
As this is an article you will be reading on some sort of electronic device, not a thesis, I am not going to explain the details or give sources for the main theories that are widely used by investment advisers in constructing portfolios. What I will explain is that by far the most common approach is to mix asset classes based on the historic (sometimes very historic!) way the main asset classes have behaved in a positive and a negative economic climate or ‘bull’ and ‘bear’ stock markets.
The basic idea is that people buy shares when the economy is doing well and corporate profits are rising but they buy nice safe government loan stocks (Gilts and Treasuries in the UK and US) or maybe gold bullion when there is a recession on the cards. So if you mix shares and fixed income stocks, you will lower your portfolio volatility. Of course, you will make less in the good times, but lose less in the bad times. Most investors find volatility in the value of their assets to be stressful, so less volatility must be ‘good’!
But how do we know what proportion of shares and fixed income stocks gives the most volatility control for the least loss of investment return over the very long term (assuming that owning only shares makes the most money if you have very good nerves and no time horizon)? Here there is much theory and a lot of it is pretty rusty in my opinion. So called ‘modern portfolio’ theory was worked out in the 1950s and polished up a bit in the late 20th Century.
A common presentation offered to investors is the “efficient frontier’, which sounds like something that might be needed in Ireland after Brexit, but is in fact a chart of all (or in reality a very large number of simulations) of the possible combinations of non-correlated assets, based on historic data. From all the possible data points, it is possible to see that a certain combination of assets would have delivered a specific return and a specific level of price volatility. In theory, if you know how much risk you want to take, stated as an average level of volatility, you can see what asset mix might work and what sort of returns you would get. There is usually a curve plotted to show the ‘ideal’ asset mixes for each level of volatility.
Reality check
Such charts and explanations have the merit of sounding logical, being based on some proper academic work and being widely accepted. But does the system work? The answer is: some of the time. As was famously suggested by the writer Nassim Taleb in his best selling book ‘The Black Swan’, investors are most hurt financially by the truly unexpected and the truly unexpected WILL happen, so we need to have ways of dealing with it. The so-called Modern Portfolio Theory is not fit for purpose. The mathematician Felix Mandlebrot (of fractal maths fame) also seeks to demolish the assumptions basis of the theories summarised above.
Taking a real life recent situation – the 2007/8 financial crisis – we can observe that shares and loan stocks and property investments all fell in value at once, by quite significant amounts. The classic approaches to diversification failed utterly and there is good reason to think they would fail again, because of the way the world is now much more dependent on algorithms (if you want a deep read on that, the book Sapiens is well worth the time – there is a blog post about it). Yet many investment products are sold, portfolios built, ETFs put together and so on using exactly the same old rusty and likely unserviceable theories.
What to do?
The answer to that question is firstly a matter of opinion and secondly a long one, so here I can only offer some pointers:
Firstly, keep an open mind and don’t ever believe that things like ’60/40′ or ‘Rainbow rated’ or ‘Scale point 4’ funds are some sort of magic bullet solution to controlling risk.
Secondly, and this is a very important point widely ignored by advisers, take account of where you in time and what has just happened and is now happening! It is plain foolish to repeat text book propositions that an asset is very low risk if you are going to buy that asset at the highest relative price for 15o years and the conditions that created that price are just about to reverse! To illustrate, UK Gilts might well have been just the thing for Mr Darcy in Jane Austen’s day, but I suggest he would not have bought any in 2017, assuming his character to be intelligent! To get his revalued (from GBP10,000) income of about GBP900,000 per annum, he would have needed the equivalent of GBP30 million of capital in Gilts in 1803, but if he wanted that yield in 2017, he would have needed to cough up the equivalent of nearly GBP100 million. He might well have thought he should found a bank instead!
Thirdly, check for correlation of returns over various time periods. NotHarry has never allocated money to North America as an asset class based on something like the MSCI Global benchmark, because the US market is so closely correlated with the UK that you get no diversification benefit and add currency risk (so more volatility, not less). You only have to watch the news every day to prove that. Of course, I do invest in US company shares, but by making more thematic and more focused calls (eg buying a technology fund).
Fourthly, remember that cash is the out and out best asset for damping volatility, so it is a legitimate asset class. Even if you are getting a pittance in interest, you still get a large payout from cash during a market crash if having the cash to meet your near term needs means you can hold your other investments and not sell at big losses. The ‘peace of mind’ or ‘don’t sell at the bottom’ dividend from holding adequate deposit funds is not easily quantified, but it is there.
Fifthly, and this is another point frequently missed by professional advisers, understand that even in a single market, like Europe or Asia, there are thousands of businesses and not all will see the same change in their share prices in a crash. Something that may be wildly out of fashion now may be so cheap that even after a crash it does not get any cheaper. For example investing in the mainstream Asia Pacific region a short time after the 1996 currency crisis would have enabled investors to diversify away much of the risk of the ‘dot com’ crash which mainly involved shares in the US and UK , because they would have bought bargain basement companies. Special Situations, Recovery, Opportunity or similar named funds that invest outside of the mega cap businesses with a decent part of their money ought to be in your portfolio. Specifically focussed funds may also be well diversified from their parent asset class – for example a Russian fund from the Emerging Markets sector. Here fund manager selection and checking the details is important.
Finally in this short list, seek out fund managers that think in modern ways and run funds that use modern techniques to add diversity. These may be Absolute Return funds, but only a few of those are really any use, or they may be multi asset or ‘macro ‘strategy funds. If volatility is bad for the value of your shares, why not invest in volatility itself – the perfect hedge? This is what the best managers can do. Again research and manager selection is critical. The funds list available to subscribing members will feature some examples.
Summary
It is sadly true that the investment adviser community is floundering at the moment in its attempts to create truly diversified portfolios. The world is different and a lazy approach has prevailed for too long. Apply common sense, check details and get a range of opinions and you may well assist your adviser in building you a better portfolio! If you are a DIY investor, don’t go for cheap solutions, ‘magic bullets’ or off the shelf packages. Put in the work, play with on-line tools and look at some charts. Subscribing members can of course seek further enlightenment by contacting me personally for educational and generic information.