One of the most effective risk management tools available to investors is diversification across multiple asset classes (e.g. equities, bonds, property and cash).
It is widely accepted by professional advisors that investors are able to reduce the risk of significant declines in their portfolio by holding a range of asset classes. In fact this is the basis of Modern Portfolio theory, and won Harry Markowitz the Nobel Prize!
One of the primary objectives of diversification is to avoid excessive correlation, as there is a tendency for certain asset classes to move in tandem. Since many unlisted alternative asset classes can often respond differently to market conditions and changes in the economic environment they represent an attractive way for investors to balance the risks inherent in their portfolios. A portfolio that’s exposed to multiple asset classes is therefore generally better protected from extreme market fluctuations since not all asset classes will experience the same price movements, and declines in one may be offset by gains in another.
Equities, also known as stocks or shares, represent ownership in a company and their value will move in line with how well that company performs. Equities can therefore offer capital growth as investors are able to receive a share of the company’s future financial performance. In addition, investors can receive income through the payment of dividends. Of the major asset classes, equities have historically shown the most potential to deliver over the longer term. However, equities can be very volatile and past performance isn’t always a good indicator of future results.
Investing in global equities can reduce a portfolio’s volatility since UK and international equities may experience ups and downs at different times. Nevertheless, there can be additional risks associated with international investments, such as currency risk, liquidity risk and country risk.
A bond is a loan made to the bond’s issuer, whether it’s a company, a government, or some other institution. Typically, the issuer promises to make regular interest payments and to repay the face amount of the bond once it reaches maturity. Different types of bonds entail different levels of risk – for example, a UK government bond is considered low risk, while a bond issued by a new technology firm which is yet to make any profit would be considered very risky.
For the vast majority of individuals, their major investment in property is the home they own. One way to add to your property investments, however, is by diversifying into commercial property. One relatively easy way to achieve this is by investing in specialist property funds, run by professional managers although it is fair to see that recent performance post Jun 23 has highlighted that investors must take a long term view of such funds.
The most common type of cash investments are bank and building society savings accounts and money market funds. Money market funds are investment vehicles which invest in securities such as short-term bonds to enable institutions and larger private investors to invest in cash for the short term. Cash investments offer liquidity and are historically the least volatile of the major asset classes. However, they also typically provide the lowest returns and are therefore more generally used for short term saving.
A Diverse Portfolio
In order to select which asset classes to invest in, investment professionals often give different pairs of asset classes correlation values, known as correlation coefficients. These can range from +1.00 (perfect correlation – two assets rise and fall identically) to -1.00 (perfect negative correlation – one asset rises as strongly as the other falls).
Equities and bonds are often considered to have a low correlation close to zero, which means that a combination of these two asset classes provides good diversification benefits. In contrast, property and commodities are often quite well correlated with equities and therefore have less of a diversification benefit.
Despite many of these considerations, every investor will have a different asset class allocation, which is likely to change over time with their needs. There is no standard solution to the question ‘what is a well balanced portfolio?’ as there are hundreds of different ways of combining investments based on your own situation, goals and attitude to risk. Working alongside a financial advisor can help you understand the risks associated with each asset class, and give you the knowledge you need to design an investment plan that meets your objectives. Alternative assets such as tax-efficient investments should be considered as part of this portfolio construction process.