Monday, 18 August 2014

Is it important to diversify my assets?

Diversification is one of the most basic principles of investment and investing. The reason it is important to diversify your investments is because the investment markets can be very difficult to predict. By being well diversified you can protect your downside risk and hopefully reduce the volatility or swings in value within your investment portfolio.

Depending on how much risk you want to take with your investments will constitute what kind of assets you will want to hold in your investment accounts and what kind of assets you want to buy. Lets look at the table below, detailing investment returns over the last 10 years from several of the key asset classes.


Lets look at the average annual returns from each of these asset classes from '04 to '13, in order:

11.14% pa - Event Driven Equity Funds
11.13% pa - Real Estate Investment Trusts (reits)
10.42% pa - S&P 500
9.79% pa - Global Equity Fund
9.51% pa - International Equity Fund
8.54% pa - Hedge Funds
7.56% pa - Long / Short Equity Funds
5.60% pa - Bond Funds
3.63% pa - Managed Futures Funds
1.81% pa - Cash
0.72% pa - Commodities Funds
-0.27% pa - Equity Market Neutral Fund
-0.79% pa - Currency Fund
-5.57 % pa - Short Equity Bias Fund

Immediately you can see that if you want to make real returns above inflation then equities need to form some part of your portfolio. Despite the fact most of these equity funds posted losses of around 40% of their value during the 2008 market crash, they have shown the ability to bounce back.

The traditional buy and hold equity funds have produced much stronger average returns than the newer classes such as long/short, market neutral and short bias funds.

But coming back to diversification, what does this mean? As you can see from the table above its very difficult to predict which asset class will perform the strongest from year to year. With several asset classes jumping from top to bottom from one year to the next. This difficulty in prediction is exactly why diversification is important. As an example. Had you invested your money equally into each of the 14 asset classes above you would have ended with an overall return of 5.23% per year with a maximum draw down of -21.69% in 2008. Because we reduce the risk and the volatility the return becomes lower but more predictable. But lets look at a typical example of a balanced investment portfolio. Typically we would take cash out of the equation as that should be safe and liquid in a bank account. On an investment of say $100,000 we might decide to put together a balanced portfolio that looks something like this:

International Equity - 10%
Global Equity - 10%
S&P 500 - 10%
Hedge Funds - 10%
Commodities - 10%
Real Estate Investment Trust - 10%
Bonds - 40%

We have several different asset classes above so the volatility of the account should be lower than usual while still providing good, solid returns. As an example the portfolio above would have returned 7.25% per year with a maximum draw down of -23.55% in 2008 (the only year that produces a negative investment return on the portfolio shown).

So use your head when investing. Spread your risk across different asset classes within your attitude to risk. If you want to use a high risk / high potential return investment strategy or a safe, secure investment strategy to help provide an income then do so, just make sure to spread your risk by using diversity to your advantage.

Have a great day, Andrew Lumley-Holmes.

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