Diversification

One of the most important aspects of investment planning is diversification . A well diversified portfolio can reduce risk and volatility. To understand portfolio construction you must first understand the term risk. Risk is not only the chance of a capital loss but also the volatility of returns . For instance an investment over a 5 year perod may produce a profit of 50% but a closer look at the figures may show that the investment made a loss over 3 of the 5 years.

Diversification can reduce the volatility of a portfolio. Also by investing in different asset classes potential losses can be minimised. It is unlikely that all asset classes are moving in tandem. The last 5 years have shown that whilst equities have been poor, corporate bond and property returns have been positive. This has been the case throughout history.

Chart 1 enclosed shows how changing the asset allocation of a portfolio affects the returns and risk associated with a portfolio. For example by increasing the equity content of a portfolio from 0 to 60% increases the returns by 3% but the risk by 15%. An investors must decide on the level of risk by taking into consideration the affect this has on returns.

Chart 2 shows how different assets are correlated. If Equity A returns 5% and Equity B returns 5% then the correlation is 1. If Equity B returns -5% the correlation is -1. The Chart shows that, for example, as property rises 1% equities tend to fall by 3.3%. Conversely as property falls 1% equities tend to rise 3.3 %. By blending the different assets classes at any one point in the economic cycle one of those classes should provide positive returns.

In addition to diversifying between asset classes it is also important to diversify between sectors, market capitalisation and geography. For instance a utility company's share price is influenced by different factors to a technology company. A FTSE 100 stock is influenced by different factors to a smaller company.

Even within the same sector a European company differs greatly from a UK Company although in this instance the differences are being reduced by globalisation. Therefore by investing in BP and Shell a portfolio is not diversified However investing in BP and Persimmon would be diversified as one is a global oil company and the other a smaller UK based house builder.

The downside to diversification can be a short term reduction in returns . This is because it usually the same that within a well diversified portfolio as one asset is rising another is falling. Over the longer term a diversified portfolio can significantly outperform an non -diversified one.

Another aspect of diversification is the actual management of the assets. Different management houses have different investment styles. Many of you may be familiar with the terms growth and value investing. This is just a way of describing how manager choose the underlying companies they invest in. Many companies have a best ideas list and tend to invest in the same companies thus reducing stock specific diversification.

When designing a portfolio we consider the style of management and the allocation to each investment house to further reduce risk. For example a portfolio of 10 different Fidelity funds would be higher risk than a portfolio of 10 funds from 10 different managers.

As an example we will compare two funds and two companies:

Fidelity Special Situations Volatility 4.82
Fidelity UK Growth Volatility 4.79
(Two different remits from one company with similar volatilities)

Fidelity UK Growth Volatility 4.79
New Star UK Growth Volatility 6.34
(Two similar remits from two companies with differing volatilities)

By investing in both funds significant diversification can be obtained.All of the above are considered when designing a new portfolio but what one must consider is that asset allocation changes over time and portfolios should be continuously monitored.

Chart 1

Chart 2