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Saturday 01st December 2018 10:45 am

The Power of Diversification

Most investors would dream of an investment that offered a high return at low or no risk. Unfortunately, this is rarely (if ever) the case in the real world.

 

Stocks that have a higher expected return tend to be accompanied by higher risk –  as any investor would want to be compensated in extra returns for taking on extra risk.

 

So, how can investors get the highest level of return for the lowest amount of risk? The answer to this question has long been sought by investment professionals over the years.

 

One respected theory - Modern Portfolio Theory developed by Harry Markowitz identifies two types of risk, specific and systematic. Specific risk could be eliminated through diversification whereas a level of systematic risk (Market Risk) will always remain – events such as a recession can’t be predicted easily.

 

Specific risk is perfectly demonstrated by the recent falls over the last month, with many of the tech stocks - the US FAANG stocks (Facebook, Amazon, Apple, Netflix, Google).

 

Risk graph

 

They have seen their combined value fall more than $1 trillion since their recent highs earlier this year. If you held only Apple over this period, you would have lost 22% compared to if you invested in the S&P 500, where you would have lost 6%. (Date – 03/10/2018 – 28/11/2018).

Apple’s fall over this period was the equivalent of $261 Billion in value. To put this in context, the MSCI Argentina index (The index covers approximately 85% of the Argentine equity universe) is currently valued at $18 Billion.

Patisserie Valerie has also made the headlines of late, the company was involved in a fraudulent accounting scandal that revealed a £40m black hole in its accounts. The chairman rescued the company by giving it a £20m loan. This gave Patisserie Valerie time to raise further funds from investors (£15.7m) by new shares at a heavily discounted price of 50p. The new shares valued the company at £70m, prior to the scandal it was valued at £500 million. The company shares are currently suspended.

 

Multiple examples of specific risk can be found by simply spending 5 minutes on Google:

 

  • Bitcoin/USD is down 70% YTD
  • Facebook after the Cambridge Analytica scandal lost $35 Billion
  • Danske Bank fell 15% in one week following a money laundering scandal.

 

It is simply impossible to accurately predict which companies will become subject to financial and corporate scandals. There will always be a level of unforeseen risk when it comes to investing, but by diversifying and investing in many stocks in different asset classes, this reduces the overall risk of the portfolio whether it be a result of fraud, scandal, profit disappointment, market changes or any other factor.

 

Once you have made the decision to diversify, the next question is - what is the cheapest and most liquid way to diversify my portfolio?

 

Exchange-Traded Funds (ETFs) are cost-efficient funds that track almost every asset class and sector in the world. Many of these funds offer a well-diversified portfolio of securities at very low cost, with the ability to be traded as easily as a share listed on an exchange (unlike a mutual fund). They are one of the most efficient ways to diversify a portfolio and are the instrument SCM Direct uses within all its portfolios.

 

Across the SCM Direct Portfolios - The Bond Reserve Portfolio (GBP) currently holds 11 ETF’s, the Absolute Return Portfolio (GBP) 22 ETF’s and the Long-Term Return Portfolio (GBP) 23 ETF’s.  However, as seen below, because each individual ETF holds many securities within it – a basket of baskets, the portfolios are incredibly well spread.

 

*As at 31/10/2018

 

Diversification, however, is only half the story, Harry Markowitz believed it was possible to have an optimal portfolio that maximised returns for a given level of risk.

 

His work went on to earn him the Nobel prize in 1952. The theory uses statistical measures such as correlation and variance to produce optimised portfolios giving the greatest expected return for a certain level of risk or the lowest level of risk for an expected return. This is led to the idea of the efficient frontier.

 

The efficient frontier concept states that if all combinations of assets were plotted on a graph that an outer curve would be created showing the most efficient portfolios – with the best risk-return trade-off.

 

Source: Research Affiliates

 

This highlights the importance of asset allocation

 

This is the process by which a portfolio is weighted according to the different asset classes (e.g. equities, bonds, property, and cash). These different asset classes provide the basic building blocks of an investment portfolio.

 

Asset allocation is not simply a function to achieve diversification, although spreading risk amongst different asset classes is important. It is widely accepted that strategic asset allocation is by far the most important determinant of long-term portfolio performance.

 

An empirical study by Ibbotson Associates et al in 2000 showed that 91% of the variance in investment returns was derived from asset allocation, 5% from stock selection, 2% from market timing and other factors 2%.

 

 

At SCM Direct we use diversification to reduce specific risk and fundamental analysis to calculate asset allocation. Regular stress test analysis is run on all our portfolios through a variety of scenarios based on Bloomberg risk modeling. Below are the results from stress testing our 3 core GBP portfolios:

 

 

For full definitions of the events, please see our investment proposition here.

 

SCM Direct uses cash or inflation as benchmarks as it is believed these are people’s primary goal for investing. However, for the point of this blog, I have used the closest comparable ARC benchmark to the relevant SCM portfolio. ARC calculates the average returns from discretionary financial managers based on their risk profile after fees.

 

 

 

To find our performance by individual years, please see our performance page

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