Reduce risk without reducing returns
All investors know the truth to the old saying, never to “put all your eggs in one basket”. However it is surprising how often this axiom is disregarded especially in times of market turmoil, or strong markets such as we are experiencing now. While it is tempting to look to traditionally “safe” asset classes such as cash and residential property in tough times; and shares in the good times, it is important to see past the noise of markets and maintain a diverse approach.
For a Balanced investor, your portfolio should have an allocation to cash, fixed interest (both domestic and international), property and shares (both domestic and international). The exact mix will depend on your objectives, time horizon and other factors however the key is to have a wide range of investments.
The key tenet of diversification is using asset classes which are uncorrelated or less correlated to reduce risk. Therefore when one asset class is performing poorly, there should be another which is performing well, to smooth out the returns. For example, while sharemarkets suffered through the GFC, fixed interest investments such as government and corporate bonds flourished. The opposite has been true over the last 18 months leading many investors to question the value of bonds in their portfolios. A balanced approach to portfolio construction should therefore reduce risk without reducing returns.
In a downturn, cash is often looked at as a safe alternative; however this reduction in diversification is disadvantageous over the long term. While moving to cash may lessen the capital losses; it will almost certainly prevent the portfolio from taking advantage of the sharemarket recovery. The funds will not be invested at the point which the market turns and the recovery begins, often the time of the greatest growth. Many investors have faced these issues over the last 2 years, and failed to capitalise on growth, placing them behind their peers in terms of total return and performance.
In the Australian sharemarket, since 1985, every negative year, has been followed by the positive double-digit return in the following year. In each of these six negative years, cash only once outperformed the sharemarket in the following year and this happened in 1989 when interest rates were close to 20%.
By the same token, if the share or property market is booming, it is often tempting to increase allocations to these sectors, even using borrowings, in order to chase greater returns.
Over the last 25 years, the best performing asset class in one year stayed the top performer in the next year only four times. Therefore it only paid off to follow last year’s winners 16% of the time. Furthermore, over the same period, if your strategy was to place all your funds with the best performing asset class from the last year, you would have you would actually have lost money six times.
Markets are fickle and past performance is not an indicator of future returns. Therefore the only way to ensure consistent returns over time, is to maintain a diverse approach. While it can be testing to stay invested when markets are volatile, the long term benefits are well proven.