The value of diversification
We believe the traditional approach of investing in Equities (stocks & shares) and Bonds (fixed interest securities) is now out-dated and in today’s market place there is a much larger pool of asset classes in which to invest.
We saw in the Credit Crunch that in times of extreme market stress, the traditionally uncorrelated relationship between Equities and Bonds disappeared and both asset classes fell in tandem.
Due to the nature of this crisis, Property assets were also caught up in the fall out and they too fell in line with most other traditional asset classes. What this crisis showed was that under normal circumstances, traditional asset classes and their usual behaviour suited clients well, however when the expected diversification benefits were really needed in earnest, they disappeared as most traditional asset classes had their valuations slashed.
There were however a number of types of assets that did maintain their diversification benefits and would have helped investors dampen down losses to achieve steady growth and protect against the major downturns that inevitably occur in markets.
This leads on to another of our main investment principles, that compounding is a major driver of long-term returns and, that avoiding large falls in the market while capturing a proportion of any upside will lead to superior returns over the long term.
|Sector: IMA Global Bonds TR in GB
Sector: IMA Global Emerging Markets
TR in GB
The chart above illustrates the benefits of compounding and avoiding large drawdowns; achieving steady consistant growth rather than riding the ups and downs of more volitile investments will often lead to superior returns.
On the surface, if you were given the choice between an investment that had average annual growth of 8.5% or one with 11.8% you would think the answer is obvious however, all is not quite as straight forward as it seems.
As you can see from the chart above, the better performing asset over the 5 years in question (2007-2012) is Global Bonds, however the average annual return for Emerging Markets is higher. What is really important is the Compound Annual Growth Rate; it also illustrates the importannce of looking at volatility and drawdown too.
The managers we tend to favour may under-perform their peers when markets are rising rapidly however they will protect capital far better in a falling market. Only by fully embracing a large number of asset classes you can achieve true diversification.
Studies, such as those of Javier Estrada at the IESE Business School in Barcelona*, have shown that historically, missing the best 100 days in the UK stock market over a generation (taken here as 42 years) would have left a portfolio c.97% behind where it would otherwise have been – a hefty figure but only half the story. If it had missed the 100 worst days over that same period of time, it would have been a massive 4370% better off (and this study only went up to 2006, missing out our recent crashes). The numbers are even more staggering if we broadened our stock investing to international markets. The same study showed on average that missing out the best 100 days of 15 international stock markets would again leave one c.97% ‘worse off’. Missing the 100 worst days in those markets would have left you a mind boggling 26,500% better off. If there are any lessons at all from history, the standout one from this research is that investors should focus very, very hard indeed on protecting the downside when investing in stocks and not worry too much about catching every rally.
Source: Saltus Fund Management
* Black Swans and Market Timing: How not to generate Alpha by Javier Estrada, Fall 2008
Follow the link below to read more about Multi-Asset Investing.
We can guide you through the financial markets...
Call us on: 01539 725855