The importance of diversification

Lorna Denny

Hello everyone and welcome to the third in our series of Investment Basics podcasts entitled Understanding Diversification. My name is Lorna Denny and I'm joined today by Vincent Juvyns of JP Morgan Asset Management. Diversification. It's not a word you come across every day, but the concept, as far as investment is concerned, is very simple. We've all heard the old phrase never put all your eggs in one basket, and the reason is clear. If all goes well, that's great, but if things start to go wrong, the result could be pretty disastrous. However, if you place your eggs in a number of different baskets, the chances are that if you hit a bumpy patch, only a few of the eggs will get broken. It's all about spreading risk, and that is the aim of diversification. Today Vincent and I will explore this concept of spreading or mitigating investment risk by creating a diversified portfolio of assets. Hello Vincent and thank you for joining the podcast today.

Vincent Juvyns

Hello.

Lorna Denny

Vincent, we've talked before on this podcast series about setting investment goals and understanding the levels of investment risk that might be required to meet those goals. If we could move the conversation on now to the importance of creating a balanced or diversified portfolio of investments, is there a word you would ask us to keep in mind here?

Vincent Juvyns

Yeah, it's really a word or many words. To me, diversification is probably the most important thing to do when considering the management of your wealth, asset management, generally speaking, it's probably the most important rule. There's no one-size-fits-all. As you already alluded to diversification, the different types of diversification, depend on your own risk profile, background tolerance to risk and long term objectives.

Lorna Denny

And I think the word resilience is something we should be looking to achieve and that would mean coping with short term moves in the market. If we could take a step back though, and define our terms, what are the different types of diversification we should be thinking of in order to build in this resilience?

Vincent Juvyns

Well, when you diversify your portfolio, you want to diversify it away from some risk under different type of risk. Usually you will try to address an economic risk, such as the recession. In that occasion, obviously having a portfolio consisting of fixed income instruments and equities will do relatively well in the sense that equity will be under pressure in such an environment, while bonds will do generally well in a recessionary environment because rates will decrease. So that's the first way to think about resilience, and then you have inflation which we have discovered recently is also a risk. You need to be able to address through diversification and we have seen that traditional diversification through only stocks and bonds didn't work quite well in an inflationary environment because correlation between stocks and bonds moved up alongside inflation. In this type of environment, you have to find other diversification means beyond fixed income and equities. We're thinking, for instance, to alternative asset classes which do a better job at protecting a portfolio against inflation. We shouldn't forget one of the key risks we are all facing which is the longevity risk. We all risk to outlive our savings if we are not ambitious enough in terms of our investment goal. So it's important obviously to minimise risk, but at the same time, being invested and keeping some optionality in a portfolio to ensure decent long time return in line with your investment goals.

Lorna Denny

Yes, that's a very good point and we can also look at geographical and industrial sectors having a mix of these sort of areas that we're investing in. But if we could zoom in a bit on diversification through holding different types of asset classes, where would an investor start with that?

Vincent Juvyns

It's allocating your assets to certain asset classes with certain expected return and obviously bearing the consequences of this in terms of volatility. It pretty much depends from your risk tolerance. If your defensive profile you will definitely have more fixed income securities than equities in your portfolio. On the other hand, if you have a higher tolerance to risk, you will obviously have a higher exposure to equities versus bonds. This will give very different portfolio outcomes both in terms of performance but also in terms of volatility. So there are probably as many diversification as there are investor. It all depends from our own profile, although there are obviously some constants in every bucket in terms of average level of fixed income or equity. Obviously, recently we have seen a greater exposure across the risk profile to new asset classes such as alternatives which have done a good job in the recent past to protect investors from inflation and also to provide a decent level of high income and stable income, which is also a feature which is important for many investors when they consider diversification.

Lorna Denny

Yes, of course. Inflation has coloured investment over the last couple of years. But just take it back a couple of steps, what now could we expect that say equities or fixed income would respond differently to any given turn of events?

Vincent Juvyns

Usually when you have an economic downturn, you have corporate earnings under pressure, you have risk aversion among investors, you have investor saver in need of cash, so willing to sell their financial asset. Usually in this type of environment you will see equity under pressure. We've seen that historically, that's the most frequent consequence. A recession does not always lead to an equity market sell off, but it's definitely not an ideal environment for equity. On the contrary, when we are facing this economic downturn, Central Bank usually starts to cut interest rates which have an impact on market rates. You start to see that the yields on long dated fixed income securities start to decrease as well, which obviously means that the price of these securities is going up, which is usually positive from a total return standpoint. So historically bonds and equities are, as we say, negatively correlated when one goes up, usually the other one goes down and the other way around. I say usually very few occasions in history when that didn't happen. Probably the last time we've seen it was in 2022 when we faced this global inflation shock due to the war in Ukraine.

Lorna Denny

Yes, it's very important to make that point. There can always be exceptions to what we expect to happen, but in principle though, the portfolio that strikes the right balance or has the appropriate diversification between a variety of asset classes is quite critical and is this then what we mean by asset allocation?

Vincent Juvyns

Indeed, and as you rightly pointed out in your introduction, it's not putting all your eggs in the same basket. You will have eggs which perform well in some environments, and eggs which perform less in the similar environment. That's what we mean by diversification for asset allocation. We should also remember that beyond diversification itself our investment horizon is also very important. We often say that time is our friend as a diversified investor because when you have time ahead of you, you reduce the implicit risk, the implicit statistical risk of having a loss. I'm thinking, for instance, if you take a 6040 portfolio, when I look at a one year investment horizon, clearly the distribution of the performance can be very wide. We can even have negative return with this type of diversified approach. When we start looking at the five year rolling period, then with a 6040 portfolio, historically speaking you never had a negative return. So really diversification but also having a long term investment horizon are the best way to move on financial market and manage your wealth for the long term.

Lorna Denny

And I think what you've said there is really quite crucial that we should all be looking to have a long term investment plan.

Vincent Juvyns

Indeed, it is over this time period that you can reap most of the benefits of diversification. Clearly, over time you will reduce the statistical risk of having a loss with this portfolio and you will in theory enjoy a smooth ride which will hopefully help investors to achieve what is actually most important for them. It's secured their financial future ensured and then when they retire they can leverage on their well earned savings, which will ultimately have grown through their career thanks to a well defined asset allocation.

Lorna Denny

Yes that’s very reassuring and thank you for making that clear. If we could quickly recap then on my five key points from today's podcast diversification:

It's all about spreading risk.

A diversified or balanced portfolio is more resilient to market ups and downs.

Diversification comes through investing in a range of geographies, industries and indeed asset classes.

Asset allocation adjustments aimed to maintain this balance of a portfolio and spreading investments overtime can also boost diversification.

But as you said there, we should always remember that while diversification can help to reduce risk, it cannot protect us against all losses and the important thing in investment terms is that your investments should be aligned with your individual goals, your risk tolerance and your investment horizon. Thank you, Vincent, very much indeed.

Vincent Juvyns

Thank you, Lorna.

Lorna Denny

And do look out for the next in our series of Investment Basics podcasts.