Eggs in one basket and all of that…

The basic risk curve is very pretty and portrays a perfect world but the world is not perfect.

It recently came to light that some of the victims of the Hatton Garden jewellery raid saw “their livelihoods” destroyed. Not all the victims were super-rich, but instead normal people saving for retirement. Furthermore it appeared many of these individuals had not insured their valuables, on the simple assumption that the vault was safe enough.

I have immense sympathy for these individuals and unless we have been through something similar, it is hard to imagine what it would be like to lose everything we have saved up for.

In recent interviews with fund managers and financial planners, as well as talking to friends, one of the key messages that comes out is the power of diversification. For many, they are attuned towards an all or nothing approach.

We want growth, we use equities. We need to protect everything we have, we use cash. It appears that never the twain shall mix!!!!

The reality is that mixing or diversifying assets can be extremely powerful in providing a layer of comfort.

Back to basics

Whether we work in finance or not, the basics are stated that cash carries the lowest risk, bonds next, property a little further up the risk scale and equities even further up.

But even within this not everything is the same.

Cash is fairly simple:

You go to a bank, or building society, and give the cash to them and they pay you a rate of interest, sorted! Well not quite, today there are many things to consider; who is paying the best rate, can you withdraw money, how often are the rates paid etc. Then you need to build inflation into the mix; although this is currently zero if it increases then potentially interest actually becomes negative in real terms.

So what about bonds? Strong performance over the past 15 years (plus) and values don’t move around much (low volatility). Good alternative to cash, surely?

The reality is that with rising interest rates returns from bonds will be squeezed, they could also deliver negative returns and greater volatility. To get the best returns investors will need to decide between different asset classes – so government or corporate bonds, investment grade or high yield (so low quality), emerging or developed market. As an alternative a strategic bond fund will leave the manager to make the decisions but not all the funds are the same.

Property should be a good alternative. Buy-to-let is popular but the reality is that the income after mortgage payments, property maintenance, fees and tax is likely to be lower than most expect! Commercial property funds are usually a good option especially as the property market is buoyant at the moment. However, 2008 was a reminder that bricks and mortar funds are great when the market is going up but when people want their money, the funds don’t have the liquid assets to pay it. Property is not such a straight forward investment.

And equities – where do you go? Emerging Markets, Asia, Frontier, Japan, UK, Europe, US etc. And within that do you pick large, medium or small companies? And before you do that do you choose a fund manager or just track the index?

The basic risk curve is very pretty and portrays a perfect world but the world is not perfect.

Why diversify

At a very basic level we are likely to have different goals – for example below are two common goals:

Goal 1 – saving for a holiday
Goal 2 – saving for retirement

If we take goal 1 – this is likely to be required within the next 12 months. It is also likely that we won’t want to take any risk with this money and therefore saving as cash makes sense. The account we use will depend on when we need to access the money but it might be a simple instant access savings account. The trade-off is that any returns are likely to be minimal.

The second goal is totally different. The timescale to retirement is a key factor in determining the extent of the risk that someone is prepared to take. For 20 plus years until retirement it makes sense to invest in equities, which over the long term are proven to deliver stronger returns than less risky assets (like cash). Of course even within this there needs to be diversification geographically and potentially via sectors (industries).

The point is that if you have a pot of £10,000 (£9,000 for retirement and £1,000 for holiday) and split it between equities and cash you have diversified and reduced the risk. The trade-off is that the return might be lower when the markets go up but it provides downside protection when the markets go down, thereby reducing potential losses.

Why diversify by sector, geography and asset

If we look at the IMA Sector Return (source Morningstar) in 2012, 2013 and 2014 it would have been very hard to predict the winners.

In 2012 the winners were High Yield, Europe and Japan. 2013 America, UK and Europe and 2014 America, Gilts and Property.

If we go back to 2000 and 2001, in 2000 the winners were Property, Global Bonds and Gilts and in 2001 High Yield, Property and Global Bonds.

It is therefore very hard, and actually almost impossible, to guess which market will do well from year to year and therefore to diversify across sectors, regions and assets makes sense. And equally to rebalance each year might seem illogical but makes logical sense, because you sell down the winners before they drop and buy into the assets before they hopefully rise!

If I bet all my money on Property based on 2014 I would be disappointed because so far in 2015 it is one of the worst performing sectors. Trying to predict the future is crazy!

Investing is about getting rich slowly, it is methodical and shouldn’t be prone to panic selling. The world is such that we can check our investments daily and this produces an element of fear however if we looked yearly much of that fear would go.

To conclude – eggs and baskets

Diversification is a powerful tool and should be used not only across different goals but also within the goals themselves. Holding cash is not a bad thing if we understand the trade-off we are making.

For example, if we have £100,000 and there is 90/10 split in favour of equities, then a positive return of 5% on equities and 1% on cash will give a total return of 4.6%.

On the flip side if equities fall by 5% then the fall on the investments is 4.4%.

Of course placing your eggs in one basket can actually significantly increase the risk and investing successfully is about getting the balance right. As we said at the start we have great sympathy for those who lost their life savings in the Hatton Gardens Heist, as they must have thought no-one could break in. They took out no insurance and assumed it would never happen.

As we know from investing it can happen and does, we just don’t know when. Diversification, used in the right way, is the strongest tool in our arsenal going some way to protecting and growing assets.

NOTE: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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