Wealth Management - Importance of Diversified Portfolios

In the 1950s academics such as Harry Markowitz and Bill Sharpe proved that using a diversified portfolio for different types of investments would greatly reduce risk, often with little or no reduction in investment performance. Whilst some of their other conclusions that using mathematical formula to predict returns and the absolute relationship between risk and return are still debated within investment and academic circles, the use of a diversified portfolio to reduce risk and maximise returns is almost university accepted.

Some assets are highly correlated and move in similar ways in different market conditions. Obviously an investor investing in shares in four banks is only slightly more diversified than an investor with one bank share. Investing overseas will help but with the advent of globalization many markets now move in similar ways. To obtain real benefits from diversification completely different types of assets should be chosen where historically their movements have not been correlated. This has however been severely tested in recent markets as Investment banks and hedge funds dumped assets to raise cash investments of all types seemed to be falling.

The type of asset that could be included in a portfolio for wealth investor is indeed diverse and even in these recent most troubled times asset classes like government bonds and gold rose.  The spread of assets is an important area.  There are still some very respectable investment groups that only asset allocate into shares and fixed interest securities.  Whilst this may provide a better spread than just using a single asset class it is hardly a diversified portfolio.  For our own clients even when investing in collective investments i.e. unit trusts, investment trusts or open ended Investment companies (OEICs) which are typically suitable for portfolios up to £200,000-£250,000 we would typically split investments according to the client's risk profile across the following asset areas;

Cash, fixed interest securities, share based funds in UK, Europe, North America, Far East, Japan and emerging markets, property funds (although not in the current market) and commodity funds. The availability of fund supermarkets that act as an administration platform and give access to a wide range of funds from many different managers allow a diversified portfolio to be created for small values so even a single ISA can have a spread of funds.

The idea of a hedge fund that can make money even in falling markets is attractive but scandals like Madoff and the general lack of regulation makes most sensible investors cautious. Luckily there are now a number of properly regulated funds from major investment companies that use the same techniques and this adds to the diversity of a portfolio.

With cash returns so low a return to a spread of investments is a move many investors will have to make but care needs to be taken to ensure they are getting genuine diversity and regular reviews and rebalancing.

 
Ian Smith BA (Hons), APMI, FPFS, IMC, CFP.
Director & Chartered Financial Planner
Central Wealth Management Limited
Unit 36 East Moons House
Oxleasow Road
Redditch
B98 0RE
 
Also at 29 Harley Street
London W1G 9QR
Tel 0845 0066 204
Fax 0845 0066 254
www.centralinvest.co.uk
ian@centralinvest.co.uk
 
Central Wealth Management Limited is an appointed representative of Central Financial Planning Limited which is authorised and regulated by the Financial Services Authority.