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The mechanics of diversification

John Baron explains how the portfolios reduce risk over time
The mechanics of diversification

No change to the two portfolios during September allows this month’s column to continue to reflect on the role of the investment principles that guide these portfolios. Recent columns have reminded readers of the merits of remaining invested despite the concern about market levels, and of the importance of diversifying a portfolio’s dividend sources by way of company size, geography and theme, given the extent to which re-invested dividends contribute to total returns over time.

But as an investment journey progresses, it is also important to diversify away from direct equities generally – for market corrections are part of the investment cycle. While few investments will emerge unscathed from such a correction, an increased exposure to less correlated assets will help to reduce losses and so protect past gains. This is important if financial goals are about to be achieved. Such an approach can also contribute to generating a higher income when perhaps it is most welcome.


An important discipline

With markets making new highs, diversification is an important investment discipline that can too easily be overlooked – it can be seen by some as an unwelcome guest at the party. And yet, if embraced correctly, this discipline can not only protect past gains, but also help to reinforce other important disciplines such as remaining invested through the investment cycle, and not being whiplashed by volatility. Indeed, an appropriately diversified portfolio can better take advantage of market dips and so enhance returns.

The aim of diversification is to reduce portfolio risk by investing in ‘uncorrelated’ assets – asset classes that tend not to move in the same direction over the same period. When the term is related to investment, it usually means reducing exposure to equities in favour of less correlated assets. Bonds, commercial property, renewable energy, commodities, infrastructure, ‘real assets’ (such as physical gold, rare coins and stamps) and cash are, to varying degrees, examples.

There are no fixed rules as to the pace and extent of diversification, or the types of asset classes to be employed. An investor’s risk profile, time horizon, income requirement and investment objectives are key determining factors. There are numerous nuances to this art. But there are some general principles that can be helpful and examples of how diversification is achieved.

The four ‘seasonal’ portfolios (Spring, Summer, Autumn and Winter) covered on the investment trust website reflect an investment journey over time and, as such, best illustrate how we gradually increase diversification. The relevance to readers here is that the Growth and Income portfolios in this column are in fact the website’s Summer and Autumn portfolios, which have been renamed when reported on in the Investors Chronicle since 2009.

When starting, it makes sense to focus on equities because of their history of superior returns over the long term – so the Spring portfolio consists only of equity holdings, as longer time horizons usually allow greater tolerance when it comes to volatility. However, as time passes, the portfolios become increasingly diversified.

One of the key asset classes employed is bonds – especially corporate bonds. As interest rates remain relatively low courtesy of the global debt scenario, bonds should continue to act as a good counterweight to equities. Each tends to be driven by different economic forces, particularly when it comes to perceptions about inflation – as such, when one rises in price, the other usually falls. Accordingly, the weightings in the Summer, Autumn and Winter portfolios gradually build in ranges of 5–10 per cent, 15–20 per cent and 25–30 per cent, respectively.

Other less correlated assets also become increasingly evident as the journey unfolds, including commercial property, renewable energy, infrastructure and commodities. Commercial property continues to look attractive, particularly in the regions, as the economy moves forward, given the lack of investment in this property cycle and dearth of good-quality yield elsewhere. Exposure across the four portfolios rises from 7.5 per cent in Spring to 20 per cent in Winter, and gradually changes in nature from direct equities to physical property.

Renewable energy and infrastructure are included because of their high exposure to inflation-linked revenues and greater resilience to the economic cycle courtesy of their underlying investments. Weightings start at 3.5 per cent in Summer and finish at 21 per cent in Winter. Commodities also feature to a lesser extent given they remain out of favour and should also benefit if perceptions regarding inflation tick up. Finally, cash should never be ignored – it is one of the few asset classes that will hold its value in a major correction.

Overall, how many asset classes should one employ? The answer, as with investment generally, is to keep it simple – four or five asset classes usually suffice. Warren Buffett once said: “Wide diversification is only used when investors do not understand what they are doing.” Too much diversification also increases costs.

Meanwhile, in addition to greater diversification, a further objective as time passes is for the website’s portfolios to produce a higher – and, importantly, growing – income. Commercial property, renewable energy and infrastructure, together with a greater focus on higher-yielding equities within the portfolios’ declining equity weightings, all help to achieve this goal. Accordingly, the Autumn and Winter portfolios currently yield 4.5 per cent and 5.9 per cent, respectively. Such asset classes also help the Dividend portfolio achieve a yield of 5.0 per cent


Remember to rebalance

Although rebalancing is a separate discipline, it can assist in ensuring diversification remains on track – indeed, it is one of the first principles of investing, and yet again is often overlooked. However, do not rebalance too frequently. Keep it simple and dealing costs low – for most investors, an annual rebalance is usually sufficient depending on how markets have performed.

Evidence certainly suggests it pays to rebalance provided one’s risk profile and investment objectives remain in sync – for it can significantly enhance returns over time. The concept is simple. A 60/40 bond/equity split may, because equities perform well, turn into a 70/30 split. Forbes has shown that $10,000 (£7,515) invested by way of a 60/40 split in the US in 1985, and rebalanced annually, would have been worth $97,000 in 2010 – whereas an unbalanced portfolio would have been worth $89,000.

Furthermore, it is sometimes forgotten that as much attention should be given to the process of liquidation as financial goals are about to be achieved, as to the running of an appropriately diversified portfolio. A gradual and balanced liquidation as the finishing line approaches is one method. There are others. Peace of mind should never be underestimated, particularly at the end of a long investment journey!