Diversification: Unpacking what it means for investors in volatile markets
You may be familiar with the saying: “Don’t put all your eggs in one basket”. While its origin is debatable, its meaning is largely agreed upon; don’t concentrate all your efforts in one area or you could lose everything!
This is especially true when it comes to investing. If history has taught us anything, it’s that investments that are in favour one day could be completely out of favour the next. To reduce the risk of losing your money, it’s a good idea to spread your investment based on your objectives – also referred to as investment diversification.
One of the more common ways of diversifying your investment is to invest in asset classes that are unrelated to each other. In other words, assets that react differently to the same event. When deciding on your asset allocation, it’s important to have an idea of the type of returns you can expect to receive and how the different classes move in relation to each other.
The table below shows the various asset class returns over recent years. Unsurprisingly, the best and worst performers tend to change every year and are unpredictable. Also, certain asset classes seem to have more varied returns relative to others. Take bonds and equities, for example. In 2008 bonds returned 17% while SA equities returned -23.2%. Fast-forward five years later to 2013, bonds returned 0.7% while SA equities returned 21.4%. Over the past nine years there have been only two instances where the difference in annualised returns between the two asset classes has been less than 5%.
The reason for the varied returns is that bonds and equities tend to react very differently under the same market conditions. For example, bonds are generally more sensitive to rising interest rates compared to equities, while equities are more sensitive to negative investor sentiment. By holding both asset classes, you reduce the risk of loss should a single event occur that negatively affects one of the two asset classes.
Diversification, however, is not an exact science, and there may be instances where market conditions can negatively impact both asset classes simultaneously. While spreading your investment allocation across asset classes is one way to reduce your risk exposure, there are others as well, such as investing across different currencies, geographical regions or even fund managers with different investment styles.
A downside of spreading your investment allocation is that you may dilute your investment returns over time. Going back to our bonds and SA equities example, SA equities (although more volatile) have generated higher returns over time relative to bonds. As shown in the graph below, adding bonds to your investment may help absorb some of the downside risk, but at the cost of reducing your investment returns over the long term.
The trick is having the right mix that not only reduces your exposure to risk but that also serves to enhance your investment returns. Getting the combination right can be tough, which is why many investors choose to invest in multi-asset class unit trusts, where the asset allocation decisions are left to the experts, such as in the case of the Prudential Balanced and Inflation Plus Funds.
Prudential’s multi-asset class funds use asset allocation to achieve very different objectives. While protecting investors against downside risk remains a common thread across these funds, the Balanced Fund is geared to be slightly more aggressive (with a higher maximum equity exposure) compared to the more conservative Inflation Plus Fund (which has a lower maximum equity exposure). This allows investors to choose an option that best suits their investment needs and risk profile.
If you are uncertain as to how to go about diversifying your investments, or if you need some help choosing the right multi-asset class fund for you, we suggest getting in touch with a good independent financial adviser to help you with your investment decisions.