Diversification and it’s Importance
Should we be making significant changes to our investment strategy due to the impact of Covid-19?
For most of our clients a key element to their Financial Planning is holding investments. This could be in their pensions, ISAs or various other investment wrappers. The type of investments that clients hold will be determined by a number of factors, but most importantly what the aim for the assets are, as well as how much risk they want to take, and how much risk they can afford to take.
As people’s circumstances change so does the type of investments they should hold and regular reviewing of our clients’ portfolios is a really important part of the ongoing service we deliver, this may involve altering the type of investments held, or in a large majority of cases, simply maintaining the carefully constructed approach already in place.
For all our clients we will look to breakdown the investments they hold into the following categories:
Low Risk
Low to Medium Risk
Medium Risk
High Risk
We continually stress the importance of a balanced portfolio and the importance of holding investments in several types of assets, across different sectors and countries, as a way of diversifying overall investment risk. Certain assets can be volatile, but by investing in a wide range of different assets the aggregate risk of the investment is reduced, it may sound like something from Star Trek but this is what is known in the industry as the efficient frontier!
A typical portfolio will consist of a mix of Equities, Fixed Income (that’s loans to companies, governments and other entities), Cash, Commercial Property and what are known as Alternative Investments such as Gold, Infrastructure, Structured Products and Commodities.
The breakdown of our clients’ portfolios are carefully constructed taking into account the typical risk and return characteristics of these various asset classes, and are designed to be held for the longer term rather than being changed as a result of the type of market conditions that we have recently experienced.
When looking at how portfolios are impacted by the current situation we do not have a crystal ball and cannot see the future, however we can look back on history to give us some pointers as to the trends that are apparent from previous investment market setbacks.
Looking at the current position, whilst we have certainly seen a recovery through April and May, following the significant falls in share market levels during March, we are, on occasions asked the question whether now would be the time to make some changes and disinvest some of the holdings. The focus is always on the share market and to be fair this is the engine room for returns, but the vast majority of clients have a much more balanced portfolio than a pure share portfolio, including all of the assets highlighted earlier. So generally, the falls experienced by clients are at a more moderate level than just looking at share market movements.
That said during March, we saw share prices around the world fall by in excess of 20% and all asset classes suffered to some extent, although sovereign debt and gold suffered less and recovered more quickly. So, would we be better disinvesting or should we hold onto the medium and high risk assets that are predominantly shares?
Goldman Sachs, one of the world’s largest investment banks has done a significant amount of research into the impact that share markets suffer during different types of market falls and the average length of time that market setbacks take before firstly, the bottom of the market is reached and secondly, how long it takes to recover.
Where the falls in markets are event driven, such as the one that we currently face, the peak to trough average declines in the region of 28% and these declines tend to last on average approximately 9 months.
The average time to recover from the peak of the market before the setback on average approximately 12 months for such setbacks. These figures are quite clearly statistics and, by their nature do not reflect accurately a specific pattern nor do they predict what will happen looking forward from now. In addition, there could be some debate as to whether this will remain an event driven market fall, or whether it may become systemic as quite clearly the impact that lockdown is having on the health of the economy may be longer term, particularly, if we do not see the current relaxation continue and if we were to see, for instance, a second wave of infection resulting in further lockdown measures.
The statistics do, however, point to an inescapable truth and that is that given time, investments as a general asset class always recover and whilst there may be casualties along the way in the form of specific companies, or certain sectors or geographical areas that take longer to recover, by ensuring that our clients are invested in a widely diversified range of investments, we are giving the assets the best chance of producing returns above cash and, perhaps more importantly, above inflation over the medium to long term. The majority of assets are actively managed within our client arrangements and the underlying fund managers are repositioning the holdings to take what they believe is the best position to ride out the current uncertainty and benefit from recovery opportunities.
Trying to time investment markets is notoriously difficult to get right and a study undertaken by JP Morgan using the Standard and Poors 500 index as an example, (which is the 500 largest companies within the US stock market) highlights that over a 20 year period from 1st January 1999 to the end of 2018 that 6 of the best 10 days of market performance occurred within 2 weeks of the 10 worst days. It goes on to also highlight that if you had missed the best 10 days of the market over this a 20 year period, you would have cut your overall return in half! That is the significance of missing the best days in the market.
What this teaches us is that the investment markets will provide positive long term returns, but there will be bumps in the road along the path and therefore, it is important that we develop a strategy that is in line with our clients long term objectives and requirements but also their attitude to risk and capacity to accept losses.
It is not possible to achieve returns without accepting some risk and our aim is to ensure that the level of risk that our clients accept remains appropriate for their circumstances, objectives, and needs.
CAPITAL AT RISK — The material in this article is for information purposes only. Please ensure that you clearly understand the nature of any investments described and the potential risks relevant to them. Past performance is not a reliable indicator of future performance and the value of an investment and the income received from it can go down as well as up.
