Diversification is an important strategy for investors and is when you spread your money across different asset classes and also investment types.
The goal of diversification is to spread risk and improve the consistency of your investment portfolio.
The financial crisis and subsequent monetary easing, has affected the way certain assets have performed and also the make-up of a well balanced portfolio. Below, we look at how investors are diversifying in today’s market.
Asset Class Diversification
The main asset classes are listed below:
|Cash||Saving and current accounts
Premium bonds and other NS&I products
|Fixed interest securities||Government bonds (GILTS)
Overseas bonds (Treasury Bonds, Bunds etc)
Local authority bonds
|Equities||Shares in individual companies
Buy to let property
Art and antiques
Other investments that do not fall in four main asset classes above
To build a diversified portfolio, you need investments where returns have not historically moved in the same direction and to the same degree. That way, if one part of your portfolio is declining, the rest can be growing or at least not declining as much.
For example, bonds and equities tend to do the opposite to each other. The advantage of having both of them in your portfolio is that one of them should always be rising. So if one is doing really badly, the other should be doing well.
There are many ways to diversify, even within a single kind of investment. For example, with equities you can spread your investments between:
Large and small companies
UK and overseas markets
Different sectors (industrials, financials, oil, technology etc)
A good portfolio will reflect an investor’s needs in terms of return, risk and term. To maintain a well-diversified portfolio, it is essential to invest across a range of opportunities within each investment type.
The systematic risk of investments is always there and cannot be diversified away. As such, diversification can reduce risk only up to a certain point. Once a portfolio is well diversified according to the investors risk appetite, additional investment within the same asset class will not be a benefit to performance.
This is often a criticism of funds whereby they have to invest a pre-determined percentage of the fund within a particular investment class within a specified time. At the same time, many funds are limited in the level of investment into any individual opportunity. Whilst this ensures the fund invests into a wide range of investments within each asset class, it can lead to over-diversification that can be detrimental to returns.
Diversified Portfolios and the Financial Crisis
During the 2008–2009 bear market, even though many different types of investments lost value at the same time, diversification still helped contain overall portfolio losses.
Below we consider three portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; an all-share portfolio; and an all-cash portfolio. As you can see, the diversified portfolio lost less than the pure equity portfolio in the downturn, and while it trailed in the subsequent recovery, it easily outpaced cash and captured much of the market’s gains. A diversified approach helped to manage risk, while maintaining exposure to market growth.
Diversification helped limit losses and capture gains through the financial crisis and recovery
|January 2008 through the market bottom, February 2009||5 years from the bottom: March 2009 to February 2014||2008 to 5 years from bottom: January 2008 to February 2014|
Source: Strategic Advisers, Inc. Hypothetical value of assets held in untaxed accounts of $100,000 in an all-cash portfolio; a diversified growth portfolio of 49% US stocks, 21% international stocks, 25% bonds, and 5% short-term investments; and all-stock portfolio of 70% US stocks and 30% international stocks. This chart’s hypothetical illustration uses historical monthly performance from January 2008 through February 2014 from Morningstar/Ibbotson Associates; stocks are represented by the S&P 500 and MSCI EAFE Indexes, bonds are represented by the Barclays US Intermediate Government Treasury Bond Index, and short-term investments are represented by US 30-day T-bills. Chart is for illustrative purposes only and is not indicative of any investment. Past performance is no guarantee of future results.
The above example does depend upon a consistent approach by the investor. Selling overvalued investments and buying on dips when assets look cheap, can reduce the risk of losses whilst boosting prospective returns. In reality many investors chase investments that are performing well in buoyant markets, back investment fads and further more follow a flight to safety during market downturns. This behaviour leads to missed opportunities and it is important to maintain an objective view on the value of assets.
As you can see from the table above, a diversified portfolio of shares and bonds was still heavily hit by the 2008 downturn. This is where investors need to create a tailored investment plan; defining your goals and time frame and in particular your capacity and tolerance for risk. To achieve the higher returns possible, an investor has to be able to handle making losses along the way and not panic. If investing in only bonds and cash, an investor is accepting low returns in return for lower volatility.
Crashes in the financial markets demonstrate that in times of crisis, the traditional asset classes become more correlated and as such offer less diversification. Additionally, for much of the past decade since the financial crisis, investors have become used to prices rising for both equities and bonds. This has been a direct consequence of the Quantitative Easing and ultra-low interest rate policies introduced by Central Banks to drive up asset prices. With these state-backed support mechanism now being withdrawn in the US, Eurozone, UK and Japan, this anomaly between equity and bonds may be about to change. For this reason, many investors are now broadening their exposure to alternative investments to offer a higher level of diversification to help weather uncertain times.
As shown in Table 1, investors who held their nerve for five years after the lowest point of the financial crisis came out almost 30% up with the diversified portfolio. However, for any investors with either the diversified portfolio or the all share portfolio that was maturing in 2008 or early 2009, it would have been a disaster.
Table 2 below uses a portfolio evenly split across equity, debt, cash and gold.
The results demonstrate that the stellar performance of gold combined with the stable returns from debt and cash meant that the portfolio achieved a very small profit during the major downturn of the financial crisis. At the same time, the return in 2009/10 was 27.04% significantly lower than the 93.78% that would have been achieved by equity alone. Generally, in years where equities showed returns of over 10%, the equally diversified portfolio including gold showed significantly lower results. In years where equities achieved returns of 10% or less, the equally split portfolio out performed, resulting in a profit in each of the last 10 years.
A diversified portfolio can give more consistent returns
Year-wise returns from some asset classes have been quite volatile in the past 11 years. The diversified portfolio was more stable.
Figures are returns from the asset classes during the financial year. Negative returns marked in grey (source The Economic Times Wealth).
Whilst Table 2 uses what would be an unusual portfolio for private investors, it does offer an insight into how alternative investments can offer a higher level of diversification. In building a diversified portfolio, investors should consider alternative investments and decide whether they can fit into their tailored investment plan. Alternative investments, whilst generally only representing a small percentage of an overall portfolio, can have a significant impact on the portfolio performance.
At CSS Partners, we concentrate on venture capital and listed companies with the potential for investors to achieve high capital growth. As our clients are looking for higher returns from smaller companies, they accept that is generally only possible from higher risk opportunities.
Venture capital whilst often structured as a combination of equity and debt, should be considered as an alternative investment as private companies can often not be directly affected by the vagaries of stock and bond markets. Additionally, economic downturns can present the opportunity for private companies to build market share as customers look to increase returns through adopting new technologies that can increase margins.
The majority of our venture capital investments will qualify for the Enterprise Investment Scheme (EIS) that offers significant tax breaks to investors. EIS shares can be used as a risk management tool to limit the downside to as low as 38% of monies invested for the highest rate taxpayers and also maximise returns through tax free profits on investments held for three years or longer.
For listed companies, we will raise development capital through convertible loan notes rather than equity. Significant upside potential is a key criterion companies have to meet in order for us to consider raising capital through convertible loan notes. Obviously, such returns are not possible without significant risks. Convertible loan notes enable investors to speculate in listed companies with high growth potential whilst retaining the income and seniority of debt. Convertible loan notes in smaller companies could offer additional diversification for investors as they are a hybrid of two asset classes. (click here for more information on convertible loan notes).
CSS Partners has raised over £170m for entrepreneurial companies since 2001. To learn more about how we enable private investors seeking higher capital growth to invest with confidence in smaller companies click HERE.
Investments offered by CSS Partners are not appropriate for all investors. Our free client service aims to be of benefit to high net worth and sophisticated investors looking to achieve higher returns.
The information in this website is provided by CSS Partners LLP. This website has been approved for the purposes of section 21 of the Financial Services and Markets Act by Charles Street Securities Europe LLP (CSSE), which is authorised and regulated by the Financial Conduct Authority. CSS Partners is an appointed representative of CSSE.
Any views or opinions expressed in this blog are those of the author alone, except where specifically stated that they are the views of CSS Partners LLP.