There is no guaranteed route to success when it comes to investing, but the data below illustrates why it is important not to hold all your eggs in one basket.
13 years of asset class performances
A widely-held belief is that shares deliver the best returns over the very long term, at least among the main asset classes.
The Barclays Equity-Gilt study shows that over the last 116 years, UK equities have delivered annual returns of 5%. By comparison, UK government bonds, known as gilts, have returned 1.3%.
But the story is more complicated than this. As you can see from the table, no one asset rules the roost for a sustained period, underlying the importance of diversifying your portfolio.
Here, we explain the merits of diversification.
A crucial imperative for most investors is not to lose money. This is always a risk with investing, but diversifying may mitigate that risk.
Consider this example: If you invested only in commodities between 2003 and 2007 you would have made a return of around 15%, according to the data.
If you invested in 2007 and held until the end of 2015 you would have lost around 3%. Over the entire 13 years, your return would be just 0.6%. But if you had diversified, evenly splitting your money across the five assets, your return would have been 5.1%.
This example is given to make a point. An independent financial adviser can help with a sensible asset allocation plan.
The same can apply when looking at how to spread your money geographically.
Despite globalisation, major financial markets can often perform very differently – Japan’s stockmarket flourished in 2015 while major US shares when sideways.
This is the same for sectors within the stockmarket: when banks suffered during the years of the financial crisis, pharmaceutical stocks rose.
Retaining access to the money you need
How easy is it to buy and sell the assets in your portfolio?
If your portfolio is full of commercial property, then the answer will be not very easy. It can take a long time to complete the sale of an office block and measuring its value is difficult, therefore your portfolio would be described as illiquid.
If you owned a property portfolio between 2003 and 2006, when demand was soaring, liquidity was not an issue. But when the credit crisis hit in 2007, it became hard to sell.
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Some funds that invest in commercial property even prevented some investors from selling, as has happened recently.
Diversification allows you to balance your portfolio between illiquid but potentially profitable assets such as property, and more liquid (easier to buy and sell) assets that you have access to if needed.
Smoothing the ups and downs
The frequency and extremity with which your investments rise and fall determines your portfolio’s volatility.
That is not to say volatile investments are bad investments: performance can be strong. But it can be an issue when you come to withdraw money at a time when your portfolio has taken a dip.
Diversifying your investments can give a greater chance of smoothing out those peaks and troughs.
Too much diversification?
There is no fixed rule as to how many assets a diversified portfolio should hold: too few can add risk, but so can holding too many.
Hundreds of holdings across many different assets can be hard to manage.
Fund manager view
Marcus Brookes, head of multi-manager, suggested achieving diversification by choosing assets with low correlation to each other. “In other words, holding assets with a strong potential return profile that have very little economic relationship to each other, for instance US property and Japanese equities,” he said.
But he added: “The aim should not be to invest in an asset with a poor potential return in order to diversify the risk from an asset with a good potential return, that is known as “diworsification” – risk may be reduced but returns certainly are.”
Diversification is essential to an investor to balance the risks posed by investing in financial markets. While you may not enjoy the stratospheric gains of a portfolio focused in just one area of the market you are also less at risk of enduring the plunging lows.
This is important to financial planning. It gives investors a better, although not guaranteed, idea of how their investments may trend in the future, which allows them to better prepare for retirement or other future plans.
Please remember, past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and you may not get back the amounts originally invested. Also, the asset classes shown herein reflect widely used proxies for each market segment, respectively, and investors cannot invest directly in these indexes.
Important Information: The views and opinions contained herein are those of David Brett, Investment Writer, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.