17 Apr 2020

Why asset class diversification is critical for investors

Patrick Duggan

Wealth manager, Investec Wealth & Investment

There are some core principles when it comes to investing that always apply, irrespective of what’s going on in the market.

While market commentaries abound daily on all manner of topics, they have little to no relevance the very next day (and sometimes even the next hour, in times of crisis). There are, however, some core principles when it comes to investing that always apply, irrespective of what’s going on in the market. 


Being at home during lockdown has afforded me an opportunity to think. As an amateur blogger, I find writing cathartic and over the past week I have been thinking about retirees and especially those who rely almost exclusively on their investment portfolios to provide them with income.

The current crisis must be an enormously stressful period for retirees, as Bruce Cameron wrote about in the Daily Maverick on 24 March. 

 

For me, this time reminds me, more than ever, why asset allocation is everything for retirement savings.

 

What follows in italics are some of the thoughts on asset allocation from an article entitled ‘A Modern Approach to Asset Allocation’ penned by Matthew Cochrane of the Motley Fool in July 2018.

What is asset allocation?


The phrase "Don't put all your eggs in one basket" is another way of saying that no one should risk all their resources on any single idea, venture, or asset. Put simply, if all your eggs are in one basket, and the basket breaks or spills, then you'll lose all your eggs.


It's especially important to follow that advice in your financial life by diversifying your investments across different types of assets and securities. Ideally, diversification lowers risk in a portfolio while still enabling returns high enough to achieve an investor's financial goals. For instance, a portfolio consisting of just one stock is far too risky – no matter how strong the bullish argument for that stock may be. A variety of factors could derail the investment, including fraud, deteriorating economic conditions, and increased competition.


At the same time, investors who choose a less "risky" investment class – say cash or bonds - will probably face other risks. Namely, while these investors face far less danger of losing their principal, they run a very real risk of not achieving returns high enough to reach their goals or even maintain their buying power in the face of inflation.
 

The importance of asset allocation


The aim of diversification is to avoid each extreme, allowing investors to achieve high returns while reducing volatility along the way and making it unlikely that they will suffer from a permanent loss of capital. The primary means of accomplishing this is through asset allocation, the practice of dividing investment money into different classes of assets – such as stocks, bonds, property, and cash – that will act independently of each other. Some more exotic asset classes include cryptocurrencies, gold, fine art, commodities and much more. 


Studies show that asset allocation is a larger contributor to a portfolio's overall returns than even individual stock selection. A 2000 study by economists Roger Ibbotson and Paul Kaplan concluded that more than 90% of a portfolio's long-term returns were driven by its asset allocation. 
 

So, what is the perfect asset allocation for my portfolio?


The best way to allocate assets in your portfolio is largely a personal choice, dependent upon many factors including your age, risk tolerance, and financial goals. Your own personal situation plays a huge role, too. For instance, I would give far different advice to two different 35-year olds, both married with two kids, if one was earning a median salary while the other had just won the Powerball lottery.


In other words, there is no perfect asset allocation, there is only a perfect asset allocation for you. Not only is asset allocation personal, but it's also dynamic. It changes over time as you age, your financial situation changes and your goals evolve.


Weighing the risk vs. the time horizons of your investments


Only Doc Brown from the movie ‘Back to the Future’ and his time-traveling sports car could tell you the perfect asset allocation for your portfolio. The rest of us have no way of seeing the future. All we can do is draw reasonable conclusions from what history tells us. The best way to accomplish this goal would be to look at the time horizon for when we might need the money we're investing.


Any money that investors might need within a year's time should be in cash. Period. Taking a chance and investing that money in bonds or stocks is foolhardy, as there is a significant chance that a percentage of your principal could be lost before you need it. Keeping the principal safe and liquid is a smart thing to do for any money that might be needed quickly.Money that might be needed in the next two to five years should be in relatively safe, income-producing investments – think cash and fixed income instruments.


Finally, any money that's going toward goals further than five years out, such as retirement (or sustaining purchasing power in retirement), should generally be invested in stocks. This is because stocks, over long periods of time, far outperform nearly all other asset classes, even though they may lose value in a given year. In The Motley Fool Investment Guide, the Gardner brothers write:
 

Invest money you plan on keeping in the market for at least five years. (We recommend a lifetime.) Stocks can and will go down. Sometimes a lot. And sometimes the market will take years to recover and reach new highs. But the long-term prognosis is tremendous ... Holding periods of ten years resulted in positive returns 88 percent of the time. For twenty- and thirty-year holding periods, that number jumps to 100 percent.


The relationship between risk and diversification


Many investors mistakenly believe that if they increase their portfolio's diversification, they decrease its risk. This is not necessarily true, especially for investors who spend time studying individual stock investments. For these investors, a concentrated portfolio might increase returns and decrease risk, even if their portfolio's beta – a measure of volatility – is higher than the market's average. In Warren Buffett's 1993 letter to Berkshire Hathaway Inc. shareholders, the Oracle of Omaha explained this concept:
 

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as 'the possibility of loss or injury.

He continued:
 

If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.

I largely agree with this concept. At the end of the day, however, you must decide what is best for you. Only you know your long-term goals, and only you know how much risk you're willing to take with your money. That being said, understanding proper asset allocation can go a long way toward helping you achieve your long-term financial dreams.
 

Conclusion


As advisers, we spend much of our time trying to get the asset allocation right for a client’s unique investment objectives and risk profile.

 

Asset allocation will typically be based on a client’s situation, his/her needs today and in the future, and his/her ability to stay the course during adverse market conditions. At the same time, we also acknowledge that it’s important to note that asset allocations are not static, but fluid and need to be revisited regularly. In times of crises, for example, you just may have to be more thoughtful about how you spend down your portfolio, your assumed inflation rates, how much you spend early on in your retirement years and your withdrawal rates.

 

Risk categories too are generalisations and may change as a client gains experience as an investor or as his/her circumstances change, such as retiring. They should be used in the construction of a portfolio that is appropriate for a client’s needs.

 

Remember, when assessing asset allocation/risk profiling, a client needs to distinguish between:

 

  • The psychological willingness to take risk (risk attitude). 
  • The financial ability to take risk (risk capacity); and 
  • The need to take risk (required risk) - the risk required to meet objectives, to avoid falling short of goals or to avoid wealth being eroded by inflation. 

 

As always, your trusted investment manager at Investec Wealth & Investment can help you to identify and manage an appropriate asset allocation to suit your investment objectives and risk profile. 

About the author

Patrick Duggan

Patrick Duggan

Wealth manager: Investec Wealth & Investment

Patrick is a senior private client wealth manager with Investec Wealth & Investment, specialising in providing holistic investment planning advice to some of South Africa’s high net worth and ultra-high net worth individuals, families and their associated entities.

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