The temptation among investors is to stick to what you know. That is no bad thing. It is a strategy championed by pioneers of investment such as Warren Buffett.
It can work when the market is rising and you have picked the right asset. However, it is also important for investors to also consider the merits of diversification.
The table below underlines the importance of spreading your money around. Doing this can potentially help reduce risk and maybe even improve the long-term performance of your overall portfolio. It shows the performance of some of the main asset classes in each year. Of course it’s important to note that past performance is not a guide to future performance and may not be repeated.
Equities relates to world stock markets as measured by the MSCI World Total Return index.
“Govts” relates to the performance of government bonds around the world and property relates to the returns from UK commercial real estate, such as shops and offices.
More detail on the indices used for each asset can be found at the foot of the table.
What’s happened and why?
Commodity prices – the value of raw materials – have suffered most in recent years. The global financial crisis hit demand and prices for nearly all sorts of commodities, such as oil, copper and aluminium, fell sharply.
If you had invested £100 in commodities during the worst spell for the sector – between 2011 and 2015 – it would have shrunk to £49. This represents a compound annual growth rate (CAGR) of -13.5%. CAGR smooths out the progress of your investment over a period of time, providing a clearer picture of the annual return.
Commodities made a comeback in 2016 largely due to huge infrastructure building proposals by governments in the US and China. But even with the 11% recovery in that year, the £100 you invested in 2011 would still only be worth £54 by the end of 2016.
Equities on the other hand have enjoyed a relatively prosperous period. Low interest rates and central banks’ unrelenting support of financial markets have provided fertile ground on which stock markets have flourished.
If you had invested £100 in equities in 2011 it would have been worth £170 by 2016 – a CAGR of 9.2%. That includes a 6% loss in the first year.
It is impossible to predict winner and losers with any great precision during a specific period. It is only in time and with hindsight that investors can say with certainty what has and has not performed well.
To manage the uncertainty and guard against losing money investors can diversify portfolios. That means spreading your investments around different assets.
For instance, if you split your £100 investment and put half in commodities and half in equities between 2011 and 2015 you would have been in profit by £3.20, rather than suffering a loss of £51.50 if you put all your money in commodities.
What are the benefits of diversification?
Reducing risk: A crucial imperative for most investors is not to lose money. This is always a risk with investing, but diversifying may mitigate that risk.
Retaining access to the money you need: In times of stress the ease in which you can buy and sell and asset is critical to the survival of your investments. For instance, selling property can take a long time compared with selling equities.
Smoothing the ups and downs: The frequency and extremity with which your investments rise and fall determines your portfolio’s volatility. 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.
Marcus Brookes, head of multi-manager at Schroders, suggested achieving diversification by choosing assets with low correlation to each other. “This means holding assets with the potential for strong returns that have very little economic relationship to each other. For instance, this could mean holding US property and Japanese equities,” he said.
Brookes has diversified his portfolios by backing gold, and even cash, given that bonds and equities, in some regions, look expensive.
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 so are returns.”
What is the best and performing asset class since 2003?
Shares were the best performing asset since 2003, adding fuel to fire of the widely held belief that shares deliver the best returns over a long period.
Commodities have been the worst performing asset in the last 14 years. They are the only one of six assets, which includes cash, shares, government bonds, property and company bonds, that would have lost investors’ money had they been invested since 2003.
In real terms, £100 invested in shares in 2003 would now be worth £306.75 – an 8.3% annual return. £100 invested in commodities would now be worth £94.41 – a minus 0.41% annual return.
What £100 invested in 2003 could theoretically be worth now
Please remember that 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.
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.