Diversification is a simple concept – everyone, at one point in their life, will have been warned against putting all their eggs in one basket. When it comes to investment, genuine diversification is about spreading money across different companies, asset classes (from equities and bonds to more specialist areas), geographical regions and fund managers.
The wisdom behind doing this is largely about reducing risk. Asset classes tend to behave differently in different economic conditions so, in a certain environment, equities might do well, for example, while bonds may struggle. In this situation, someone invested purely in bonds will be at risk of capital losses whereas a more diversified investor will be less exposed.
The relationship between asset classes is known as correlation and blending less correlated assets (which behave differently against a certain backdrop) is a good way to reduce risk. Perhaps the easiest way to understand this is the idea that every asset class has its day in performance terms so a well-diversified portfolio should have something to offer whatever the economic and market climate.
Source: Lipper, Liontrust. Calendar year, 10 years sterling, net returns to 31 December 2016. Past performance is not a guide to future performance.
The table above might seem a dizzying collection of colours and figures but simply shows how the performance of different asset classes varies from year to year. The idea is to follow the colours: so if we take UK bonds, for example, it is represented by the light red and to find its performance each year look for that coloured box. In 2009 and 2010, for example, we find UK bonds were having a tough time relative to other asset classes with the second-lowest return but, in the following years, it has topped the table twice – leading the pack in 2011 and 2014.
In addition to reducing risk, choosing between asset classes – or asset allocation – can also have a major impact on returns. A huge range of studies over the years have shown that asset allocation – how much of your money you put in each asset class – is a key determinant of overall investment returns. Of course, the decisions on which equities or bonds you buy are important as well but the split between these areas in a portfolio may be the most important factor behind the performance it generates.
Asset allocation usually breaks down into strategic and tactical.
Strategic asset allocation: Strategic positions are designed for the long term. In asset allocation funds, strategic weightings are usually reviewed once a year.
Tactical asset allocation: Tactical calls are more short term in nature, usually to take advantage of changing economic or market conditions.