What’s covered?
- What is diversification?
- How can diversification benefit investors?
Capital at Risk: All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.
A balanced diet should look like a rainbow, with green vegetables, red and white meat, and maybe even some black charcoal bread – the new, fancy kind you can pick up these days in farmers’ markets. If your shopping basket looks uniformly beige, you know you’re probably making the wrong decisions.
The same principle applies in the world of investment. It’s never a good idea to load up on just one thing. We may have heard of the so-called wonder investment or miracle stock whose share price just keeps growing and growing, but in reality these kind of securities are few and far between, if they exist at all. And often these so-called miracles have another name – a bubble, and bubbles burst, just like tech stocks after the Millennium.
That’s why diversifying – or spreading risk – not just between stocks and bonds but asset classes, sectors, countries and even currencies is important. The wider your diversification, the less likely you will be hit by one stock dipping or even by a general market downturn. In other words, a balanced diet keeps you in better shape for longer.
And look out for this word: correlation. If something is correlated with another thing, it means they tend to behave in the same way. Being truly diversified is the opposite of owning securities that go up and down together. For example, stocks and bonds tend to have a negative correlation – moving in opposite directions since around the year 20001. When the US dollar falls in value, that of gold tends to go up2. Also, a country’s stock market and the value of its currency usually have a negative correlation. For example, when Sterling hit a 30-year low after the Brexit vote3. UK mega caps (the biggest companies in the market) were bolstered because they generate revenue from and export to overseas markets – and as a result of the low currency became even more competitive 4.
Let’s look at why diversification matters. Say you buy a portfolio of 100 US companies. You might think you’re diversified and that, if one stock crashes, it won’t affect the other 99. Except it might, because if all those stocks are in the same sector – pharmaceuticals, for example – every single stock could be affected by a changing circumstance, such as a new law halting drug prices. Chasing one sector because you’ve read a positive headline is like a fad diet: it doesn’t make any sense to eat just watermelon for weeks on end.
Now suppose your basket of stocks contains a mix of sectors, like pharma, tech and industrial companies. After you buy them, a new president is elected and vows to raise corporation tax for all of the largest companies in the country. This could affect shareholders’ belief that the companies will continue to improve their profit margin and their share prices could all fall. In supermarket speak, this is the equivalent of buying cheese, yoghurt and cream – it’s all dairy.
Now you own a mix of US stocks and US bonds. If the Federal Reserve announced a big move on monetary policy, both could sell off, or rally, depending on the announcement. (This time you have food poisoning? It’s all been cooked in the same restaurant.)
And imagine now you invest in a range of small, medium and large companies in the US, across many sectors, as well as a range of bonds. But what happens if you’re a UK-based investor? A change in the relationship between Sterling and the US dollar could translate those same returns into far less money.
So, as we can see, diversification goes above and beyond what you might at first consider it to be.
Diversification lowers risk, not just because you are spreading your money between lots of different securities, but also because different asset classes come with their own risks.
As a rule of thumb, the greater the proportion of equities in a portfolio, the greater the risk and the more potentially volatile the investments will be. Bonds tend to be less risky than equities, but having said that, owning high-yield or junk bonds might be riskier than owning shares in some very large blue-chip UK companies, so investors have to consider each stock or bond on a case-by-case basis.
While a typical portfolio for a balanced risk investor tends to be about 60 per cent equities and 40 per cent bonds, increased globalisation and correlation5 means it might be a good idea to spread your investments between an even wider range, including corporate bonds (company debt), gilts (government debt), commercial property, alternatives, such as gold and oil, and cash.
Asset classes don’t always behave as we’d like them to. Gold saw a massive sell-off in 2013 after a 10-year climb6, while the price of oil halved in 20157. The US has now seen 10 years of positive returns since the 2008 financial crisis8 ]. We don’t know what the future holds. So all we can do is stick to sensible advice, eat lots of greens and get a good night’s sleep.
1 Source: Business Insider, The BlackRock Blog, An Obscure Market Indicator Could Be Very Useful for Investors
2 Source: London Bullion Market website, Gold’s Negative Relationship with the US Dollar
3 Source: Pound Sterling Live, chart of GBP vs USD since 1976
4 Source: Bloomberg, chart of iShares Core FTSE 100 UCITS ETF over five years
5 Source: BlackRock, Increased Correlation: A Challenge to Diversification
6 Source: Goldprice.org
7 Source: MoneyWeek, Brent crude oil performance
8 Source: Google Finance, S&P 500 performance
MKTG1118E-661215-2050293
