Diversification is a very important investment principle, used to manage risks within an investment portfolio whilst still achieving desired returns.
This principle of diversification is usually achieved by investing across a broad spread of different investment asset classes that behave differently.
It is typical for an investment portfolio to include exposure to cash, fixed interest securities, equities and property. Further diversification is then added within each asset class – for example by investing in gilts and corporate bonds within the fixed interest asset class.
A new study from Capital Generation Partners has found that, despite greater levels of asset class diversification in portfolios over the past decade, portfolio volatility has not been reduced.
The study looked at 30,000 institutional investment portfolios and found that sufficient diversification was achieved by sticking to mainstream asset classes.
A typical portfolio with 60% in equities and 40% in fixed interest had an annualised return of 3.7% over the decade, with volatility of 11% and a maximum drawdown of -27.8%.
As a comparison, a portfolio with greater diversification across equities (40%), fixed interest (30%), private equity (8%), property (8%), commodities (7%) and hedge funds (7%) achieved an annualised return of 5.2%, volatility of 10.6% and a maximum drawdown of -30.8%.
Capital Generation Partners conclude that there is a fundamental misunderstanding of how asset classes perform and the correlations they deliver.
Adding lots of non-mainstream asset classes to a portfolio does not always result in diversification because they tend to behave in similar ways. ‘Alternative’ investments, including private equity, are not really alternatives because they behave in such a similar way to equities.
In some cases this attempt to diversify though investment in non-mainstream asset classes exposes investors to greater risks than the volatility they are attempting to reduce.
The conclusions from this research support our approach to portfolio construction at Informed Choice.
The second point of our investment philosophy says: “Diversification using mainstream asset classes can reduce risk without destroying returns”.
Put simply, we believe in simplicity and cannot see any justification in the additional cost, complexity and risk of using non-mainstream asset classes outside of cash, fixed interest securities, equities and property.
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