Diversification’s last stand?

Like many of us in the modern world I seem to spend a lot of time in my car, and like many of us I find podcasts the best way of making the daily commute somewhat bearable. A favourite of mine is The Rest is History which takes a canter through some fascinating topics. They recently covered the Battle of the Little Bighorn and Custer’s Last Stand, the battle in which a hubristic Lt Col Custer led his 7^th Cavalry against a larger force of Native Americans and suffered an overwhelming defeat¹; which naturally got me thinking about Investment Management.

One person whom history has judged particularly harshly is a subordinate of General Custer, Captain Frederick Benteen. Commanding his own force, he received an order from Custer saying to come quickly and bring ammunition, and it is thought that perhaps this relief would have been enough to prevent the infamous fate of the 7^th Cavalry had Benteen acted with more urgency. However, the podcast made the point that the somewhat straightforward order was, in reality, ambiguous. The ammunition was not with Benteen and was located a few miles in the opposite direction to the battle – so was Benteen to come quickly, or to get the ammunition? He could not do both.

This has since become one of the main principles of military planning; the selection and maintenance of the aim. In other words, being absolutely clear about the one thing that must be done so that in the fog of war, everyone knows what they are trying to achieve.

This is what made me think of investing; you cannot expect any one asset class to be able to achieve everything an investor wishes. Equities can give the best long-term return to beat inflation, but you cannot also expect them not to have severe drawdowns on the way. Bonds can give a predictable source of income, but you cannot expect them to appreciate in value to the same extent. Therefore, it is vital that an investor really considers what their overall objective is.

However, the advantage we have is that we are not tied to any one particular asset class, and this is what is at the heart of portfolio construction. By combining different asset classes, you can achieve a better risk adjusted return, or a ‘smoother ride’. The father of modern portfolio theory, Harry Markowitz, reputedly described diversification as 'the only free lunch' in that it removes stock specific risk, however market risk will always remain. Factors affecting market performance are immensely complicated and nobody can claim to be able to predict what is going to happen.

Therefore, we seek to build a portfolio that will meet a client’s objectives under a variety of conditions.

So how does this work in practice? Different asset classes will perform differently under market conditions therefore by combining them, you are sacrificing a bit of the upside exposure for some protection on the downside. It is important to note that this is a very crude example and in there are a multitude of other factors at play. For example, periods of unusual market volatility can increase correlations between asset classes, which proved to be a painful surprise for many investors in 2022 when both their bond and equity allocations saw sharp falls due to the impact of sustained high inflation. This is where alternative asset classes such as commodities or hedge funds come into play and can provide a return that is even less correlated to equities and bonds.

A final thought on risk taking. Custer had a swashbuckling reputation and his self-belief led him to many successes over his military career, until it took him one step too far and ended in abject disaster. Whilst it can be difficult to miss out when risky assets are on the charge; there are far too many examples where these ‘investments’ have performed spectacularly well, until they haven’t. By taking a balanced and diversified approach you are optimising your chances of successfully meeting your long-term financial goals.

For a no-obligation initial chat to understand your needs and how we might be able to help you in the future, please give us a call on +44 (0)161 832 6868.

The value of investments can go down as well as up and you may not get back the full amount invested. Your capital is at risk.

References

¹ The Rest is History, “Custser’s Last Stand: the Final Showdown” 23/5/24

To contact or read more about Jack Roper, visit his biography here.

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The information contained in this article does not constitute a personal recommendation and the investment or investment services referred to may not be suitable for all investors. Any opinion or estimate expressed in this publication is Investec Wealth & Investment (UK)’s current opinion as of the date of this article and is subject to change without notice. The value of investments and any income from them is not guaranteed and may go down as well as up; you may get back less than the amount invested. Past performance is not an indication of future performance.