Guide to investing – part 2 – What is investment diversification and asset allocation?
Friday 3rd September, 2021
One of the most complex areas of investing is investment asset allocation and diversification. So many questions arise around why we do it and how to do it properly. There is a plethora of information on the internet and Youtube to the extent that Ray Dalio, the famous hedge fund manager, even goes so far as to recommend an "all weather" asset allocation for the DIY investor.
In part 2 of our guide to investing, I will look to further reduce some of the mystery around investing and portfolio construction by looking at how we utilise different asset classes to build an investment portfolio which is aligned to your own personality and attitude to risk, as well as what you are trying to achieve through investing.
At the end of this article, if you still have any questions or would like some advice on building a portfolio that meets your specific needs, then please don't hesitate to give us a call.
What is diversification?
For those of you who took financial advice many years ago, you may remember a broker/bank adviser going through your attitude to risk with you. If you were low risk, they whacked you into a solitary corporate bond fund. If you were medium risk, they bolted you into a generic managed fund which invested in everything from shares to corporate bonds to property. If you were a high-risk investor, they would invest you into a developing market fund which would take you on a hair-raising tour of the heights and depths of the investment experience.
Since then, we have come to realise that the best thing to do is to spread your investments across a number of asset classes, geographic regions and industries. This is known as diversification. The reason for doing this is that the various assets classes respond to market conditions differently. As demonstrated in the diagram below, a bull market will generally result in shares being up and corporate bonds and gilts being down and vice versa.
Similarly, certain industries may trend at different times. This was demonstrated brilliantly during the COVID-19 pandemic when certain tech stocks performed very credibly, as a result of the increased focus on virtual meetings and working from home.
Just as different asset classes and industries may perform/underperform at different times, different countries and geographical regions will also respond either positively or negatively to the current political and economic climate prevailing at the time.
In reality it is just about impossible to guess with absolute accuracy, which assets, regions and industries are likely to perform best at any one time. However, it is possible to make an educated guess at what is likely to happen. By spreading your risk across a broad range of asset classes, regions and industries, while favouring the areas you feel will perform, you moderate the risk and volatility of your portfolio. If your predictions are correct, then your portfolio will benefit from your favouring of those particular positions. However, if you are wrong, you still have exposure to the other areas, thus moderating the under-performance and either mitigating losses or capturing at least some gain.
A perfect way to illustrate how quickly investment sentiment can change is by considering the reactions of investors pre- and post-the 2008 crash. Before the 2008 crash, investors were gorging on share markets, with the FTSE and Dow Jones shooting the lights out and the end of boom and bust seemingly confirmed. When the debt that had fuelled that growth turned around and bit world economies in the tuchus, investors dropped shares as if stung, causing the markets to spiral down like something out of the Battle of Britain. Investors looked desperately around for a safe haven and flooded into corporate and government bonds. This boosted the value of stable, well rated bonds and pushed the bond market rapidly up. The impact was so impressive that it is easy to forget that in the three years prior to 2008 bond markets were pretty poor performers. When the panic calmed down and it became clear that the world wasn’t going to end, investors looked at the share markets and realised that there were suddenly loads of shares from very good companies selling at bargain basement prices. The investors quickly sold the out of bonds and a buying frenzy started on the share markets that drove the share prices up and up. We then entered the longest bull market in history. This surging market occurred despite the Greek debt crisis, ISIS, Afghanistan and frequent predictions that it cannot go on. Some people may argue that this bull market was fuelled by quantitative easing and was therefore artificially supported by governments printing money. For actually anybody invested in the markets, I am pretty sure they were pretty agnostic about what was causing their phenomenal returns.
The anecdote above goes to illustrate the following:
- Bonds and shares react differently to different market conditions and stimuli. This means that by spreading your investment between the two you can mitigate your risk as the gains on one will counteract the falls on the other. It is important to note that Bonds and shares are not negatively correlated all the time. Sometimes they move in the same direction and many articles have been written questioning the extent of the negative correlation and whether this can be relied on as much as it is.
- Markets are emotional and not rational creatures. Warren Buffet points out that they are stoked by fear and greed. There are thousands of formulae out there for making money on the stock market. A formula can only work on an entity that is predictable. The markets are by their very nature volatile, so a formula that will make you money all the time cannot exist. Some investors, like Warren Buffet, Peter Lynch and Benjamin Graham make money on the markets by taking high conviction positions buying high quality, undervalued shares, bonds and property and holding them for the long term. If you don’t have the knowledge, experience and research capabilities of the above investment legends, then it makes sense to rather opt for investing your money into pooled investments and a sensible asset allocation designed to provide a reasonable return at an acceptable level of volatility over the medium to longer term. This allows you to control what you can control and allow for the unpredictability of the markets.
The table below (Source: Schroders, Refinitiv data correct as of 01 January 2019) demonstrates the performance of differing asset classes year on year from 2005 to 2018.
What we can see from this table is that no asset is consistently at the top of the table. Commodities are at the top of the table in 2005 and are then conspicuous by their absence from the top of the table for the next 13 years. Cash appears at the top twice, but if you think that holding cash is a formula for success, it appears at the bottom 4 times.
What this goes to show is that it is virtually impossible to consistently choose the top performing asset class. It also demonstrates that a portfolio investing in only one asset class is far riskier than one that invests in two asset classes. A portfolio that invests in only one company is a bit like going for a swim in a piranha tank with a bloody steak tied to your leg. Not advisable.
So, how do you decide on the best asset class to invest in? Well, you don’t just choose one. Rather, you invest across as many asset classes as possible in proportion to the level of risk you want to take. The more you spread your funds amongst different companies and different asset classes the more you reduce your risk and the less volatile your portfolio will be. It also means that your performance is likely to be more consistent.
You may have a company/sector/region that you favour for various reasons, and there is nothing wrong with taking a position that reflects this. However, it should always be with only a portion of your funds and with money you can afford to lose. Even Amazon has seen falls of 25% in the past.
It is important to remember that the more you diversify your portfolio, the more you dissipate your growth potential. A focussed portfolio based on relatively few asset classes and companies will tend to be very volatile, but will also have a higher growth potential. The more focussed the portfolio the higher the risk. Therefore, anyone investing solely in bond funds may think that this is a low-risk strategy, when in reality it is a very high-risk strategy due to the focussed nature of the portfolio.
By contrast, a widely diversified portfolio spread across a broad range of asset classes and companies will tend to be far less volatile, but will also lack huge growth potential. You may therefore think that exposure to developing markets in your portfolio makes it higher risk, but if that exposure is only 5% of the overall portfolio it is potentially a medium-low-risk portfolio, depending on the spread of the other holdings.
If you are wondering where to get guidance on asset allocation there are a number of online resources that can help you. However, I maintain that it is really worth chatting to a financial adviser who can talk you through your asset allocation and what is most likely to suit your needs.
What is my attitude to investment risk?
As mentioned above, you may have talked to a stockbroker or financial adviser in the past and had them discuss your attitude to risk with you. There has been a real evolution in terms of how scientific the process of determining attitude to risk has become. If you did it 15 years or more ago, your adviser would have probably just asked you if you were a low, medium or high-risk investor and invested accordingly.
Since then, things have gotten far more technical, with clients answering lengthy psychometric questionnaires, some of them quite esoteric; the results of which provides a rating determining the level of risk the investor is comfortable taking.
All of this can be of real benefit and the outcomes can be really interesting. The questionnaire is a really useful tool for removing some of the societal baggage we may have when it comes to investing.
For example, there is the investor who, on the face of it, is completely gung-ho about investing and wants to take unbelievable levels of risk to achieve sky high returns. However, when the answers to their risk questionnaire come back, they are bordering on no risk at all. It turns out they have been burned before by investing into high-risk schemes while working in Singapore. The investor approaches everything with bravado, because that is how they do business, but they actually have a high level of scepticism when it came to investing.
On the other side of the coin is the investor who is very quiet and placid and everything they say gives the impression of someone who has a medium-low approach to investment risk. However, their results come back as medium-high. Upon investigation, it turns out that they worked as an assistant to a financial adviser, while studying to become an accountant. As a result, the investor has a high level of faith in the ability of a diversified portfolio to perform over the medium to long term. They also believe that markets will continue to grow over the medium to long term and therefore they are comfortable with the volatility that may occur in the interim.
These questionnaires can also be very useful in determining your approach to delegation of investment decisions and your overall approach to the possibility of taking losses.
The key thing about these types of questionnaires is that they are only a starting point. The results should form the basis of a discussion that will help to determine the eventual attitude to risk and asset allocation. I am of the school of thought that your attitude to risk also needs to be determined by your goals, timeframe and circumstances.
Let’s say that you are 30 years old and looking to retire at 65. Your aim is to save regularly into a pension in order to be able to provide an income when you retire. I would suggest that during your first 25 years of investment you can afford to take far greater investment risk in order to maximise the amount of growth you achieve, as you have more than enough time to make up any falls in value that may occur. By maximising the growth you achieve at this point, you should end up with a larger investment pot at retirement and a correspondingly higher income. In the next 5 years you need to reduce the possibility of a substantial fall, while maintaining reasonable growth, so you should look at a more diversified medium risk portfolio that can still achieve above inflation growth, but should have less volatility. In the last 5 years, your focus may shift to capital preservation with the aim of avoiding falls in the value of your pension pot that will be difficult to recover from immediately prior to retirement.
While this is a very basic example and is unlikely to be suitable in all situations, it does illustrate the following points:
- If you need lots of growth then your portfolio should be structured toward achieving this with an appropriately focussed and risky portfolio. There is no point in saying, “Well, we didn’t achieve our goal, but we didn’t lose any money either.”
- The attitude to risk that you have now is not necessarily going to be the attitude to risk that you have throughout the life of the investment. It is likely to change depending on the time frame, growth achieved and required and the importance of achieving the goal. The importance of reviewing portfolios and attitudes to risk regularly in relation to the corresponding goal cannot be understated in this process.
You will also need to consider your capacity for loss. We have all heard the phrase, “Only invest money you can afford to lose”. Well, this is a very important maxim to invest by, when determining the level of risk you are willing to take. If you only have £100,000 and you are relying on these funds to help you make ends meet during retirement, don’t take a high-risk gamble investing in a brand-new start-up company with an above normal chance of going bust. You cannot afford this loss and a substantial fall in your fund value will negatively impact your ability to fund your future. This means that your capacity for loss is small.
Alternatively, you may have retired and taken your large final salary pension, which generates more than enough income to cover your expenditure every year. It is indexed in line with inflation, which means it should retain its value in real terms over the coming years. In addition, you will start to receive your state pension at age 67. You therefore are not reliant on any investments returns you make to meet your expenditure requirements in the future. You could therefore take greater risk with the investment, safe in the knowledge that no matter what the outcome, you will still be able to meet your expenditure requirements. This means that you have a high capacity for loss, because a fall in value will not impact your ability to maintain your current lifestyle.
Therefore, you shouldn’t only ask, “What level of investment risk do I feel comfortable with?”
You should rather determine your approach to investment risk by asking:
- How important is it that you achieve your goal?
- When does it need to be achieved by?
- What do we need to do to achieve it?
- What can I afford to lose in a worst-case scenario?
Up to a point, you need to separate your emotions from the investment process. If achieving the goal is important to you and you need to take a higher level of risk than you would really feel comfortable with to achieve it, you may need to take a pragmatic view and accept this. This shouldn’t be done on a whim and it is important that you understand the implications.
This brings me to a very important point. If you are investing in the stock markets, you are doing so because you believe that they will go up over the medium to longer term and they will perform better than cash. If this is not the case, there is no point in doing it. It is important to note that history tells us that over a 10-year period you will likely experience at least one period where markets fall 20%. During these periods the newspapers will be screaming about contraction of the economy, unemployment, businesses closing and years required for recovery. The temptation to pull out your investments at this point are huge. This is where many investors make their biggest mistake. They give in to temptation and sell at the bottom of the market, thus crystallising their losses. This cycle of buying at the top of the market and selling near the bottom is demonstrated in the diagram below.
The behaviour demonstrated above is common and research carried out by Numis Securities (Daniela Esnerova, Value of advice put at 2% as SJP returns top Hargreaves, FT Adviser, 24/09/2020) demonstrates why taking financial advice added on average 2% to an advised portfolio after costs, compared to a DIY investor portfolio. The analysis took into consideration both portfolio returns and costs.
Given that an advised portfolio is likely to be significantly more expensive than a DIY portfolio, this simply does not seem to make sense. Surely the adviser must be bringing something more to the party than just fund picking and distribution of assets to explain such a significant difference?
The researchers concluded that the key difference is the “greater long-term discipline and lower emotion an adviser provides”. Having just managed a number of clients through the COVID-19 crash, I can testify to this being true. The fall in the value of portfolios and the corresponding media hysteria meant that we inevitably had to deal with large numbers of clients querying whether they should be selling out of their portfolios. Left to themselves these negative thoughts could easily spiral out of control, resulting in a knee jerk reaction to sell. Fortunately, we were able to point out that although the FTSE 100 lost almost 36% of its value in the crash, their diversified investment portfolios were only down 8% – 11%. Not only did we convince them to stay the course, but where possible, we encouraged them to invest more money, as really good companies were massively undervalued as a result of the shock reaction to the virus.
As far as I am aware, none of our clients sold out of their portfolios and the majority of their portfolios have now recovered their value. In addition to this, those who took our advice to invest at the height of the crash, have seen a really tidy profit of 25% or more on the newly invested funds.
This brings us to the end of our guide to investment fundamentals. In part 1 we looked at the building blocks that go into making a portfolio: the asset classes. We looked at what the different asset classes are and how they work.
In part 2 we have looked at how we use those asset classes to build a portfolio. We discussed how to spread and control your investment risk through diversification and how you can tailor your asset allocation to your particular needs and approach to investment risk.
At the end of the day, you can be as scientific about asset allocation as you want. There are all sorts of formulae out there, each with staunch advocates, who guarantee certain long-term outcomes. The key thing for me is that you understand that you adopt any approach to investing that you want, but you need to be aware of the risks involved and be sure that this fits in with your overall financial plan.
In addition to this, you should never take more investment risk than you feel comfortable with out of desperation to get large returns to make up for lost time or some other personal reason. It may sound callous, but the markets don’t care about your desperation or needs to have a certain amount of money by a particular time. The markets chew up the majority of speculators. The best way to succeed is to adopt a scientific approach, investing in a diversified portfolio and holding for the long term.
This is a complex area, but if you work together with a financial adviser who does this day in and day out, you will end up with a portfolio that really suits you and your needs.
If you are thinking of investing and would like to discuss this further, please don’t hesitate to give us a call.