There’s no question that focusing on the health and wellbeing of you and your loved ones is the most important thing at this time, but for many, understanding a few core principles of investing helps to allay anxiety about their long-term financial stability.
Even before Covid-19 hit our shores and triggered a global lockdown, it was our intention to write a piece on what Nobel Prize winner Harry Markowitz called “the only free lunch in investing”, as part of our investment series. Given our current climate, it’s even more relevant that we highlight the value that carefully thought-through diversification of your investments creates.
What is diversification?
Diversification can possibly be best summed up by the phrase, ‘don’t put all your eggs in one basket’. It’s a sensible approach to many aspects of life and an important concept when it comes to investing. The concept of diversification is one of the cornerstones of Modern Portfolio Theory. It is also important when drawing the distinction between a gambler speculating with their life savings, and a successful investor making long-term strategic decisions.
Diversification is an approach to managing risk. Your money is spread across a wide variety of investments, covering multiple asset types with no bias to a specific industry or geographic area. In simple terms, it means you have a little in lots of different pots. The graphic below shows how the amount of money in the markets is split across the world.
Per cent of world market capitalisation as at December 31, 2018. Source: Dimensional Fund Advisers
With this image in mind, it’s easier to understand the risk associated with trying to pick which country or ‘pot’ to allocate more of your money to. Investing more than 5% in the UK is a bet on the UK market performing better than the rest of the world. Rather than taking on this additional risk, it’s better to invest proportionately and let the global markets grow or diminish over time. If the UK does well, it will naturally take a bigger slice of the global capital markets and therefore your portfolio.
The portfolios Life Matters invest our clients and our own money in, are highly diversified. This includes 47 countries, and more than 20,000 individual equities and bonds, capturing the benefits available by investing in the global markets.
Trying to predict the future – a broken model
The very nature of forecasts mean they are based on what is known, namely the past. People seen as experts will predict, with a false sense of conviction, what’s coming next. But it isn’t possible to see the future, and according to Yale University Chief Investment Officer David Swensen, “Sensible investors prepare for a future that differs from the past, with diversification representing the most powerful protection against errors in forecasts.”
Diversification helps take the guesswork out of investing. It was only on February 12th this year that the stock market hit an all-time high and experts were predicting another positive year of healthy returns. Research shows it’s not possible to consistently find the top-performing company, business sector, country or asset class. Diversification reduces the impact any of these elements of risk will have on the performance of your investment portfolio.
One man stands alone when considering investment track record: Warren Buffett has captured the imagination of the financial world for more than four decades. In his company’s Annual General Meeting last week he said, “I don’t believe anybody knows what the market is going to do tomorrow, next week, next month, next year.” When it comes to being able to predict the behaviour of a sector, in this case airlines, he went on to say, “When we bought, we were getting an attractive amount for our money. It turned out I was wrong about that business because of something that was not in any way the fault of the excellent CEOs [of the airline businesses].”
The table below shows the past performance of a number of different investment sectors. Each colour represents a different sector, with the sector that performed best each year at the top of the table, and the sector that performed worst that year at the bottom. Select a colour in the first column and follow it across the table to the right. You can see that the sector that performs best one year, may perform very poorly the following year, and vice versa. Does past performance give you any clues about a sector’s future performance? Unfortunately not. But it does give a very clear indication of how random returns can be from one year to the next.
Source: Dimensional Fund Advisers
A well-diversified portfolio provides the opportunity for a more stable outcome. In the graphic below you can see that security A has performed the best, and security C worst. But they’ve experienced their biggest ups and downs at opposite times. This means the average of those two equates to a less bumpy investment journey. This is shown in the Diversified Portfolio View graphic below, which illustrates the smoothing effect. Investing in a large basket of globally diversified and varied holdings bolsters this effect further.
Source: Dimensional Fund Advisers
If even an expert with Buffett’s pedigree can’t anticipate how these unforeseeable circumstances will impact companies, it doesn’t make sense to invest in a strategy that requires a knowledge of which the ‘right’ companies are and how they are going to perform within a specific time frame. This is how we have been able to reassure clients that, knowing what we know now, we would still have recommended they invest their money in the way they have.
Please note, the value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.