Diversification – The Importance of Claiming Your ‘Free Lunch’
Diversification and Investments
Diversification is the investment world’s equivalent to ‘don’t put all your eggs in one basket’. Rather than taking your savings and investing in one or two companies, you spread it across hundreds or thousands instead, usually by investing in funds.
Imagine you had two portfolios: one consisting of shares in 10 different UK companies, the other composed of thousands from around the world. The impact of one company losing half its value would be significant in the first case, but negligible in the second. Furthermore the impact of a national crisis in the UK would be substantial on those 10 UK companies, but it is unlikely to have the same effect on companies across the Atlantic. Diversification can be used to mitigate these “unsystematic” risks .
Diversification is also important as it ensures you are best positioned to capture returns wherever they occur. I recently attended an investment workshop and one of the most striking statistics was that, despite having the world’s third largest equity market, the UK only accounts for 8% of world market value (market capitalisation). This means that if you were to invest solely in the UK you are missing out on 92% of the global market and all the opportunities that lie therein.
Diversification is also important across asset classes, as well as within. It was this time last year I attended a conference where one of the main discussion topics was ‘the death of bonds’ and whether they still had a part to play in portfolios.
If one had listened and acted on these ‘experts’ forecasts they would have ended 2014 extremely disappointed as UK Government Bonds produced double digit returns whilst their equity counterparts failed to beat inflation. As noted in Andrew’s recent blog post, this highlights the importance of diversification and also emphasises the dangers of prediction.
Diversification and Investors
Diversification isn’t just important in terms of your investments; it is also beneficial for you the investor. When you have a portfolio made up of shares in thousands of different companies you will inevitably find some react differently to others when faced with the same economic situation.
For example a company that is in the oil and gas sector and a company in the aviation sector are likely to react very differently to the fall in oil prices (something we have observed over the last 6 months).
This is important for an investor as it helps to lessen the peaks and troughs of returns an investor experiences. By having a portfolio made up of companies that react differently to the same news and events you are less likely to experience those huge falls in value that can cause real worry. This allows you to achieve the returns you need but with a far less volatile investment experience.
Diversification and Brook-Dobson Brear
Our role is to be your risk manager and to ensure you are only taking risks that are necessary in order for you to live the lifestyle you want.
If we are able to achieve the same expected returns whilst taking less risk then this is your ‘free lunch’. Our portfolios are diversified within and across asset classes, helping you achieve the same expected return with a lower level of risk.
We believe that markets work and are efficient. Therefore trying to predict whether equities will outperform bonds over the next twelve months, or if the UK economy will do better than Japan’s, relies less on skill and more on luck. What we can do is ensure we are best positioned to capture the potential returns by having a well-diversified portfolio.