Diversification: Imitating the artist’s palette
Just as an artist displays many colours on his palette, an investor may choose to own many diverse investments.
Imagine you are in front of a beautiful painting. Vivid hues of blues, greens and yellows are expertly blended with shades of white, cream and taupe. The various tones sit in total harmony with each other. No one colour dominates.
In several ways, we believe the composition of a portfolio of investments should resemble an artist’s varied colour palette, diversification being one of the few principles an investor cannot choose to ignore.
But while diversifying among different investments does not guarantee against loss of capital in the event of markets falling, our view is that it can reduce the dominance of any one single investment. This, in turn, can help to generate a potentially smoother overall financial outcome for the investor, with potentially stronger returns for the amount of risk that is taken.
But what specific assets, and in what combination, can help achieve true diversification?
The theory behind diversification
For decades, the ‘classic’ portfolio has typically comprised:
- Equities, otherwise known as company shares (60%) and
- Government bonds (40%). A government bond is effectively an IOU, whereby an investor lends to a government for a set time-period in return for a fixed rate of interest.
The rationale behind blending equities with government bonds was on account of their different individual characteristics and behaviour under differing economic circumstances.
Whilst past performance is no guarantee of future results, company shares have typically performed well in a buoyant economy, their prices propelled higher by rising profits growth. Government bonds, by contrast, have typically performed better in periods of economic slowdown.
Of course, there are risks involved in both types of investments – weak economic growth can dent company profits, and weigh on share prices, while strong economic growth can lead to rising interest rates and inflation, which tend to impact government debt negatively.
The reality behind diversification
That is the theory. Now for the reality. Since the global financial crisis of 2008/2009, the relationship between government bonds and equities (when government bond prices typically fall, equity prices typically rise and vice versa) has effectively broken down. Instead of moving in opposite directions, government bonds and equities have typically moved in lockstep with each other.
Commentators lay the blame for this trend firmly at the door of central bankers who, by injecting large quantities of cash into the economy, have distorted financial markets and pushed interest rates to unprecedented low levels – leaving government bond yields (effectively the return an investor receives on the bond) close to zero. Given such a poor return, our feeling is that investors cannot rely on government bonds alone for their traditional diversification.
Introducing new ‘colours’ to the mix
So, what could investors do to introduce an element of diversification into their investments? Here’s where we believe the role of ‘alternative’ investments may come in. Alternative investments are those that fall outside of the more conventional categories of investments such as government bonds, equities, or cash. Infrastructure and gold, for example, have come into their own as real portfolio diversifiers of late, given their own unique characteristics. Indeed, our We do it for you range regularly holds many of these assets.
Diversifying investments offers no guaranteed protection in falling markets. But just as the artist uses an array of diverse colours to bring his painting to fruition, a broad mix of different groups of investments can help investors achieve their savings goals.
Remember, the value of any investment is not guaranteed. The value of investments and any income received from can go down as well as up and you may not get back as much as you had originally invested.