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Understanding
diversification

This chapter highlights the importance of spreading the risks associated with investing and how they can be reduced by creating a balanced investment portfolio.

Reduce the risk: diversify

Risk is a necessary and constant feature of investing – share prices fall, economic conditions fluctuate and companies can occasionally become insolvent. Indeed, the very returns that these assets can generate are typically there to compensate investors for the risk they take.

There are many different asset classes available to invest in, each possessing different risk characteristics. The risks for each asset class cannot be avoided, but when they form part of a diversified portfolio and are managed collectively, risks can be diluted.

You can spread your investment across a wide range of asset classes and sectors, and help reduce the risk that the portfolio will be overly reliant upon the performance of one single asset.

Speak to a financial adviser who will be able to offer further advice about investment diversification.

Asset allocation

One of the best ways to spread risk is to invest across several different asset classes. The principal choice is between shares, bonds, cash, and perhaps other ‘alternative investments’ such as property.

The different ‘risk/reward’ characteristics of each asset type are illustrated in the graph below.

The aim is to select asset classes that behave in different ways, the theory being that when one asset class is underperforming, the other is outperforming. For example, bonds often behave differently to shares by offering lower but more consistent returns. This helps provide a ‘safety net’ by reducing many of the risks associated with reliance upon one particular asset.

Sector exposure

Depending on what they sell, produce, or what services they provide, companies can be classified by ‘sector’. For example, Wal-Mart resides in the ‘Retail’ sector and BP in the ‘Oil and Gas’ sector.

Just as it is important to spread an investment across different companies, it can also be wise to select companies from different sectors.

For many reasons, companies within different sectors can perform very differently in different market conditions. By diversifying across sectors, an investor can access companies with good growth expectations, without necessarily overexposing their whole portfolio to undue risk.

For example

Commodities or technology shares are generally seen as having higher growth expectations, but are also known to be volatile and react to market conditions. Some stability can be achieved by holding companies across sectors associated with lower growth expectations, or those sectors which are less sensitive to changes in market sentiment such as pharmaceuticals or insurance.

Picking the right balance of these depends upon your own risk profile.

Make sure you have a global view

Geographical location

You might feel better investing most of your portfolio in your home market – but is it the most sensible option? According to the MSCI All Countries World Index* , as at November 2019, the United States makes up over half the global stock markets.

*A stock market index, such as MSCI World Index, is a statistical measure that reflects the value of a basket of stocks. Stocks listed within an index bear similar characteristics, such as trading in the same stock exchange, belonging in the same industry, or being similar sized companies.

Performance of markets around the world

The table titled 'Annual returns (%)' shows the best and worst performing markets and asset classes over recent years. As you can see, to be able to invest in the ‘winners’ and avoid the ‘losers’ would indeed have led to a powerful

Source: MSCI All Countries World Index. November 2019

performance, but look how hard it is to spot these. The distribution of returns is very wide, for example, in 2016, the annual return percentage was between 11.92 and -2.12. Therefore, it may be wise to invest across a variety of global markets to help dilute the risk.

Annual returns (%)

Green = Best Performing Purple = Worst performing

Source: Bloomberg as at 20 August 2019, USD, bid to bid, AAXJ US Equity, MXEUG, LEGATRUU, FNERTR , NKY, ASX and SPX Index.

Share-specific risk

The well-documented insolvency in 2008 of Lehman Brothers, one of the US’s biggest investment banks, illustrated the danger associated with investing in seemingly safe, large, multi-national organisations.

Whilst the impact would have been catastrophic to an individual with their life savings in the company, an investor holding their shares as part of a well-diversified portfolio would have seen the effect considerably diluted.

By investing in as little as 20 different companies covering multiple sectors, the majority of share- specific risk can be reduced.

Also, to ensure your portfolio is well-diversified it can be also wise to ensure that different shares represent a stake in companies of different sizes, this way you can spread the risk associated with, for example, smaller companies.

Investment style

Diversification highlights the importance of ensuring that an overall portfolio has exposure to varying types of investment styles. Some shares are held because investors believe their value is likely to grow significantly over the long term. These are known as ‘growth shares’. Others are held because they are regarded as being cheaper than the inherent worth of the companies in which they represent a stake. These are known as ‘value shares’. Please refer to chapter 3 - Understanding shares - for more information about shares.

It is important to have a blend of styles to ensure that the portfolio as a whole is not overly vulnerable to the risk/return characteristics of each individual share type.

and finally...

The key benefit of diversification is the reduction of an investment portfolio’s overall risk. This is achieved by reducing the reliance upon one particular asset class, share, sector or geographical region, to generate returns.

The premise of diversification is a simple one; whilst one asset in an investment portfolio may be declining in price, another unrelated asset may be gaining; maintaining the balance required for a healthy portfolio.

In practice, it is difficult to create the perfect balance of assets, sectors, investment types and markets to suit a specific investment objective and risk profile. However, the innate diversification qualities of collective investment schemes, combined with the ‘know-how’ of a financial adviser, can present a sound, individually-tailored diversification solution.

By investing in as little as 20 different companies covering multiple sectors, the majority of share- specific risk can be reduced.