The role of diversification in today’s marketplace

Why the golden rule of investing is even more pertinent in times of uncertainty and volatility.

Harry Markowitz, Nobel Prize winner and the founder of modern portfolio theory, famously called diversification “the only free lunch in finance.” His thinking was that by diversifying, an investor gets the benefit of reduced risk while sacrificing little in expected returns over the long term.

Markets have been on a bit of a rollercoaster ride since the pandemic and its aftermath, further exacerbated by the Russian invasion of Ukraine. We now also have high inflation and much of the world teetering on the edge of recession.

As you would expect, regions, sectors and businesses have all been impacted differently, so the question for investors is - where to take refuge? The simple answer is - diversification.

The role of diversification is not about boosting performance so much as helping to manage risk. By agreeing the level of risk that you can live with, based on your goals, time horizon and tolerance for market volatility, a diversified portfolio created specifically for you has the best chance of achieving your aims. By spreading your investment across different asset classes, industries, or maturities, you are less likely to experience market shocks that impact every single one of your investments the same.

The benefit of diversification is because historically different assets behave differently. This is called correlation. Over the long term, in most market scenarios, evidence shows that cash tends to have a very low correlation with equities and property; that property has a higher correlation with equities; and that equities have low correlation with fixed interest and bonds, for example.

This means fund managers and investors usually diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Each asset class has a different, unique set of risks and opportunities. Classes can include equities, bonds (government and corporate), ETFs, property, commodities and cash.

For most investors, therefore, diversification makes sense. You should also look to stay diversified within each type of investment. In terms of stocks, for example, this could mean diversifying across equities or funds by market capitalisation (small, mid, and large caps), sectors.

In addition, you should consider both industry as well as geographical sectors – in other words not just the UK but also the US, Europe, Japan and emerging markets for example, as not all regions do well at the same time, or to the same degree. You may want to consider a mix of styles, too, such as active or passive and growth or value. .

To summarise, the aim of diversification is to help reduce risk, so that your investments as a whole have the best chance of achieving your aims. Your actual asset mix should align with your own personal goals, objectives and attitude to risk, which means the right portfolio for one investor is not likely to be appropriate for another.

For more information on diversification or to review your investment portfolio in the current market uncertainties, talk to Kellands today.

Please be aware that the value of investments linked to the stock market and the income from them, may rise or fall depending on market conditions and that you may not always recoup your initial investment. In addition, past performance should not be seen as an indication of future returns.

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