Why diversification matters – or does it?

AIDAN BAILEY of The Fry Group reviews diversification to determine if it remains a compelling proposition in today’s investment climate.

Diversification has always been touted as a primary means of reducing investment risk, by spreading money across a range of asset classes – such as shares, bonds, cash and property. In that way, if one asset class struggles another may rise to compensate. But what happens when every asset rises or falls in tandem? During the 2008 financial crisis, the UK stock market lost almost half its value, UK property dropped 20 percent, returns on cash collapsed and corporate bonds plunged 25 percent. Likewise in 2009, these same assets experienced a strong recovery together. 
According to a number of investment managers, all asset classes look equally unattractive at the moment. For example, although equities may look relatively good value compared to bonds, it doesn’t mean they are of good value.
     According to Sebastian Lyon, Chief Executive at
Troy Asset Management, a combination of QE2, low cash returns, risk aversion and the prospect of low economic growth has driven the price of corporate and government bonds to historic highs – UK interest rates can only go up from here, pushing the price of bonds back down.
     Sebastian also doesn’t see the appeal of equities. Set against a backdrop of low growth, he cannot foresee anything positive to push equity prices forward. Equities may offer some protection against inflation, but that’s about as far as it goes. So at the moment, an orthodox spread between equities, bonds, cash and property seems to offer little protection. If these asset classes continue to react to market events with such high levels of correlation, there’ll be little point in diversifying.
     For effective diversification and capital protection cash is probably the best tool there is – at present. Unless your bank collapses, your cash will still be there for you. And even if your bank does collapse, the Financial Services Compensation Scheme will protect the first £50,000 of any loss – set to shortly rise
to £85,000.
     A wise time to diversify is when one particular asset class has fallen out of favour. While there’s no point buying equities, bonds and property when they’re all expensive, if one asset class falls out of fashion and the price slides to the point of “good value”, diversification makes sense.
Start investing in: 
• High quality sovereign bonds.
• High quality defensive equity funds.
• Funds actively managed to meet an “absolute return” objective.
• Real assets, such as gold.
Aidan BaileyBA (Hons) CertPFS AWPCM 
General Manager Singapore, International Division



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Posted by The Fry Group Tue, 21 Dec 2010 04:50:00 GMT