Weekly outlook

Spreading risk is more instinctive than you might think

By Andrew Webb, 8 April 2009

How a few pounds lost on the Grand National might pay dividends on your investments

Last weekend’s big race at Aintree was a perfect reminder that sometimes, against the odds, the underdog has the legs to romp home in fine style. At 100-1, Mon Mome was the most unexpected winner of the Grand National in its 162-year history and provides an equally unlikely lesson to investors. While a very few lucky believers would have made a small fortune at the bookie’s expense by backing this year’s National winner with conviction, only a fool would have bet the farm on such a long-shot. Most sensible punters, would have hedged their bets and backed more than one horse hoping to improve their chances of winning something – anything.

"Diversification is a well thought-out, but not over-complicated discipline that every long-term investor should consider" Andrew Webb

This instinct to spread risk rather than concentrate it too narrowly is useful in investing and is better known as diversification. Spreading your assets across different investments is one of the first and most intuitive ways to reduce risk in a portfolio and doing so has the same effect as backing more than one horse in a race.

Building a portfolio that’s "just right"

The aim of investment diversification is to reduce the impact on your wealth of one bad egg and to make sure that if something good is going on "over there", you can be a part of it. Effective diversification in an investment portfolio can be little more than just scattering one’s investments around, but there is what you might call a "Goldilocks" portfolio of mixed assets where everything is "just right".

Too few individual elements in the portfolio will mean risk remains concentrated. Each additional investment quickly reduces that concentration. Having two different investments is better than just one; three is better than two. And so on.

Too many investments though, and each one in the pot just becomes an expensive and ineffective addition. Forgive me for flogging the analogy again, but backing all 40 of last Saturday’s runners would have been pointless overkill.

Diversification is a well thought-out, but not over-complicated discipline that every long-term investor should consider.

Such is the depressed mood among investors at the moment though, one would be forgiven for dismissing this principle, instead believing that all investments are falling or have fallen together. But this view would be misguided. There have been very short time frames, days here, weeks there or the odd month when everything has come tumbling down together, but over longer periods, the pattern tends to be that as one investment fades, another takes up the running.

When equities peaked in 2007, commodities started to surge; everyone will remember the painful peak in fuel prices last summer at the top of that spike. When commodities ran out of steam in mid 2008, government bonds came into their own as investors across the world sought the safety of the most stable investments. When the world economy recovers from its current difficulties, stocks will take up the running once more.

It is this constant rotation of winning and losing assets that provides the ground for another element of diversification; one that tactically takes tactical advantage of the rotation of assets. As an investment strategy, multi-asset investing has swung in and out of favour. From the early 1980s to 2000, when apart from the odd (albeit significant) wobble, shares did little else but rise, investing in other assets alongside shares such as cash, bonds and commodities seemed only to hold-back performance. But when shares came to the end of that bull-run in the wake of the dot.com crash, multi-asset investing came into its own and since then, has done rather well.

The cycle relay

Knowing when to tilt your exposure to the different asset classes is the challenge of this strategy and relies on an understanding of where we are in the economic cycle. One way to do so is to look at the leading indicators of growth and inflation and to assess what this means to the economy. Fidelity’s Asset Allocation Director and manager of the Multi-Asset Strategic Fund, Trevor Greetham says the economy is in Reflation characterised by falling inflation and weaker than average growth. This situation favours defensive investments, but at the latter stages should allow for the move into the next phase of the cycle – Recovery.

Inevitably, with your investments spread more broadly you will miss some of the stellar performance of winning asset classes as often as be saved from the catastrophe of a falling star. In his book called Multi-Asset Investment Strategy, Guy Fraser Sampson points out that rail passengers are not concerned with the top speed of their train. Instead they are more interested, first, whether they will arrive at their destination at all, and then what the chances are of arriving safely and on time.

Multi-asset investment funds might not top the performance charts, but because they are able to exploit a steady accumulation of growth that comes from being in the right asset class at the right time, they are as unlikely to be at the bottom.

So while you might have lost a pound or two at the weekend by backing the wrong horse, you might instead have gained a valuable lesson in diversification.