Maybe you’ve started investing, maybe you’re ready to take the plunge. But if there’s one key strategy you should be aware of and that can put your restless mind at ease, there’s one key word that springs to mind: diversification. Why? Because it’s the shield that will protect you against the inevitable pendulum swings that arise in the markets - volatility.
So how exactly do you use diversification to shield you against market downturns? I sat down with professional Fund Manager, Eva Sun-Wai, who unpacks what diversification is, how to nail it and the different options that can help you achieve it.
What is diversification and why is it important for investors?
“Diversification is an important strategy that can reduce the overall risk of a portfolio. It's essentially not having all your eggs in one basket. It’s making sure that once you've identified your personal risk tolerance and time horizon, that your portfolio is exposed to a diverse range of risks, to limit exposure to a single theme, asset class or geography.”
How can investors achieve diversification through their portfolios?
“The main way in which you can add diversification into your portfolio is through different asset classes, such as bonds, equities and shares, real estate, commodities, private assets , cash and so on. The theory holds that what may negatively impact one asset class may benefit another.
Do you think it's particularly helpful for investors to diversify across different sectors and industries?
“Yes, definitely. There are vast differences in the way different industries or sectors operate. As investors diversify across different industries, they become less exposed to sector-specific risk.
“You can also diversify across borders, corporate lifecycle stages, size of companies (large cap vs small cap) and different economic themes. Within bonds (fixed income), you can diversify across the themes I have already listed but also across different maturity lengths, with different term lengths having different risk impacts.
“These are all areas where fund managers and advisors can definitely help you. On some platforms, they will have “ready-made” diversified portfolios – both individual funds and portfolios comprising of a range of funds, which you can choose between depending on your risk tolerance.”
How should an individual’s asset allocation change during different life cycles?
“Traditionally, if you're younger, you have more time to take on more risk as you have less need for immediate liquidity. But when you’re older, you may want to be able to withdraw more readily (for retirement, for example) and thus need the liquidity to do so. Some advisors may structure your portfolio in this way – being in higher risk, less liquid assets when younger (equities, private assets, real estate) and moving to lower risk, more liquid assets when reaching retirement (bonds, cash).
"A large part of what we do is diversification"
“If you're comfortable and know you've got a long time horizon, then yes, you have more time to take risk because you can take comfort that if things go really badly, you have time for the economy to recover – or for that particular theme to recover.”
How can funds help investors with diversification?
“Imagine you have £1,000 to invest and each share or bond costs £100. Naturally this means you could only allocate to different items in your portfolio. Now imagine that purchasing a unit of one fund costs £100, and each fund constitutes 100 different stocks within it. If you were to use that money to buy ten separate funds instead, you now have a (smaller) piece of 1,000 different stocks, rather than your original 10. Your portfolio is now much more diversified.
“Some of the less liquid asset classes like emerging markets or real estate or private assets, are generally harder for retail investors to access. But when you buy a retail fund investing in these asset classes, investment professionals have the correct licences and qualifications and trading abilities to then access those markets for you and help you achieve diversification.
“We are active fund managers, which means we are trying to identify the companies, industries, governments, currencies, commodities etc that are going to outperform the broader market, both on the downside and the upside. A large part of what we do is diversification, in order to enhance the risk-return profile of our funds.”
What about passive funds?
“A different type of fund is called a passive fund, meaning they track the broader market, usually through replicating an index. By buying a passive fund (often called index funds or index trackers), you can still achieve diversification as you can buy a unit of a fund that is replicating the S&P 500 for example, which is the top 500 companies in the US by market capitalisation.
"This means you still have exposure to all of the underlying companies in those indices, but you will be exposed to the broader market movements of large US businesses. By combining multiple different passive funds, you can start to achieve diversification across geographies and asset classes.”
What are the main advantages of actively managed funds?
“Building your own portfolio when you have no idea where to start can be overwhelming. Within global fixed income funds like the ones I manage, we're doing the asset allocation within a huge asset class, and that can be very appealing to retail investors who may not want to choose their own bond allocations themselves. But it very much depends on the individual.
“Active management in downturns can be very popular, where major markets are falling and the economic backdrop is uncertain. Many active fund managers can out-perform the market in such a scenario, because they can take advantage of those shifts in valuation.
For individuals who have started investing. What can they do to maintain a well diversified and ensure they continue getting the average market return over time?
“I think, broadly, there's an element of patience required. You should never assume that just because you're invested in the market, that you're guaranteed to make a positive return over time.
“I think it is important to assume that over time, these shocks do smooth themselves out because of business cycles, economic cycles and supply and demand in the market. But also, if you are apprehensive, then perhaps think about whether you want to move things around.
"If you're worried about the state of the economy, perhaps move a little bit more into bonds or a little bit more into cash. If markets are in a period of reasonable growth and stability, then perhaps add a bit more to higher risk assets. Think about what would keep you up at night. Diversification can reduce the return potential of a portfolio, but it is an effective risk management tool.”
What tips and advice do you have for people who might not have enough time to constantly stay on top of the news to inform their asset allocation?
“I don't think everyone that invests needs to be a market expert who stays on top of every item of news flow. Most people have a pension – that pension is likely invested in the market and most people are not following what their pension is doing day-to-day. You've probably at some point just had to choose a risk tolerance for that portfolio and then you've let someone else manage it.
"For your personal savings, you could invest into a ready-made model portfolio and only adjust if and when you want to. Vehicles like Stocks & Shares ISAs are great for this, as you also get tax benefits.”
Any final thoughts?
“Every individual has different goals and tolerances. Do your research, speak to advisors where you can, and be patient.”