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The saying goes: don’t put all your eggs in one basket. In the same way, it’s important that your investments aren’t concentrated in one area, but are instead spread over a range of assets across the investment universe.
Most investors will be aware that investing in a range of assets across industries and geographies is considered a sensible idea. This can help reduce negative impact from changing market conditions, without necessarily hurting long term returns.
A recent example of this has been the wildly fluctuating cost of fuel and other commodities. This has driven up the value of oil and gas companies, which lagged behind in 2020 and the first half of 2021. This is in direct comparison with several companies which had been performing well who have now begun to struggle. A diverse range of investments will have had a smoother performance over this period compared to those concentrated in one sector.
A free lunch in finance
While diversifying stock selection can offer some mitigation against risks, there will still be systemic or market-wide risks that could have negative implications. These include inflation, rising interest rates, or political instability – all three of which we are seeing in 2022.
This is why diversification should be across all asset classes, as bonds, equities, property, and alternative investments will react differently to the same market conditions. Asset allocation is important and spreading investments across different asset classes mitigates against a variety of risks.
According to Joanna Stocks, Head of Liquid Alternatives: “Whether it’s asset allocation or stock selection, this is supposed to improve the outcome for investors. I should be able to construct a portfolio that’s got similar levels of return for lower levels of risk.”
Therefore, diversification is sometimes known as the only free lunch in finance, she adds. While it’s important to acknowledge that diversifying cannot eliminate risk, by combining asset classes that don’t move in perfect sync, diversification should lead to reduced volatility, and smoother returns.
Putting belief into practice
Typically, diversification occurs at three levels: stock selection, the mix of fund managers, and how these funds are combined into portfolios.
While some fund managers will be constrained in what or where they can invest (for example, in a regional equity strategy), they should still be looking to diversify. “These fund managers will still diversify across investment style sectors and industry factors to just name a few things they may be looking at,” says Dr Sarah Ruggins, Head of Multi Asset Research. “So, throughout their processes, they will reduce stock-specific risk in their strategy by ensuring that there are various drivers of risk and return at play.”
It should also be considered how different fund managers work together in a multi manager fund. A recent example of this was in 2021, when St James’s Place merged Alternative Assets, UK Absolute Return and Multi Asset funds into a new Global Absolute Return fund. Part of the logic for the merger was that none of the original funds were diversified enough in their own right.
In creating this new fund, St. James’s Place removed some fund managers, rebalanced others, and added new fund managers. For the fund managers removed, or whose holding was reduced, it was not necessarily just related to performance. Rebalancing was also carried out to ensure the fund was sufficiently diversified.
Ruggins adds: “The result is a product with improved diversification across managers and strategies. In time, this smooths out volatility and delivers more consistent performance in a simplified structure. By ensuring clients remain fully diversified at every level, we believe this will help minimise risk and volatility, without sacrificing those all-important long-term returns.” .
Contact Jamie on firstname.lastname@example.org or +65 9167 9634 to arrange a consultation and discuss your planning needs for your financial future.
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