Diversifying your holdings will protect you from blips
IT IS an apt time for investors to revisit how they are managing risk within their portfolio; not only because of last week’s twenty-fifth anniversary of Black Monday, but also because of current risks, like the Eurozone crisis.
Risk isn’t inherently bad. The more risk you take, the more return you might get. Of course, it’s also true that the more risk you take, the greater the chances that you will lose money.
The key to investing is ensuring that risk is controlled. Investing in a variety of assets that behave differently under different market conditions helps to reduce portfolio risk by stemming volatility: when markets dip, your portfolio will be somewhat insulated; but conversely, when markets rise aggressively, you won’t gain all of the upside.
THE LIMITS OF DIVERSITY
You should “ensure your portfolio has depth as well as breadth, in terms of security types, regions and asset classes,” says David Hollis of Allianz Global Investors. But given that most retail investors only have access to traditional asset classes, he adds that the costs involved with achieving a widely diversified portfolio can “far exceed the benefits of diversification”. Since the crash in 2008, the high-cross correlations of assets – where investors hold the same assets multiple times – has made true risk diversification extremely challenging for the retail investor.
Ben Yearsley of Charles Stanley notes that “with crashes, like the 2008 financial crisis, all risk assets tend to fall in value, so, diversification has limits”. The solution is to strike a balance between assets that generate income and those that appreciate in value. This ensures that, if the value of your holdings fall unexpectedly, you can still rely on income.
In the current climate, investors may look to assets that will preserve wealth in real terms.
ACHIEVING DIVERSIFICATION
In the wake of the financial crisis, “traditional equity-bond diversification is no longer applicable due to increased cross-asset class correlations,” says Hollis. Markets are now primarily driven by liquidity. Hollis believes that retail investors need “a far more dynamic asset allocation” to combat this problem, particularly in the deleveraging environment that we find ourselves in.
You must ask how far you want to diversify: Yearsley says “diversification is essential for any portfolio, but it is possible to over-diversify”. Over-diversification can lead to cross-holdings. For example, you may hold shares in a company and also a fund that contains those same shares. “It is important for investors to know what the fund’s underlying holdings are,” since “this helps to avoid holdings in the same types of things”.
The weighting of cash plays an important role in risk management. Although it doesn’t yield much, it provides security, as well as adding a dynamic element. Tom Stevenson of Fidelity says that you should “keep some of your power dry. Crashes happen, and when they do you want to have some ammunition ready to take advantage”.
But it’s a balance. Holding excessive cash in a negative real interest rate environment is not conducive to producing positive real returns. Investors should maintain strict rules about cash levels.
Your asset allocation should be reviewed regularly. “The more risky the assets within your portfolio, the more you need to keep an eye on them,” says Yearsley. Adding that since investors rarely start with their end pot, “keeping a check on diversification can be difficult. But investors must have a coherent strategy”.
In the current uncertain economic climate, diversification is paramount. Putting all your investments in one basket is a surefire way to get egg on your face.