Asset Allocation & Diversification (FEB 2020)

We cannot know the future with certainty and this is particularly true when it comes to financial market returns, the economy, interest rates and other matters of concern to investors. We have a large and persuasive body of research showing that markets cannot be consistently timed for profit, that picking stocks, funds, or individual securities successfully is not a day-to-day pattern, and that eminent economists cannot predict future moves in the economy any more accurately than chance guessing. Everyone is equally handicapped when it comes to predicting the future.

Asset allocation is a process through which you and your adviser select a mix of investments that are appropriate for your financial goals. It can help you generate returns for a given level of risk and preserve capital — regardless of market conditions — by spreading investments in your investment and retirement plans across asset classes such as stocks (equities), bonds (fixed income), alternative investments and cash.

This is important for the long term because, as the chart below shows, a single asset type that grows (or outperforms) one year could drop (underperform) the following year. For example: 

In 2008:

• UK stock market delivered -30% 
• World's stock markets delivered -16% 
• UK Government Bonds delivered +13% 
• UK Property market delivered -20% 

And in 2009:

• UK stock market delivered +30.12% 
• World's stock markets delivered +15.30% 
• UK Government Bonds delivered -1.16% 
• UK Property market delivered +0.45% 

In addition, asset allocation can help you mitigate risk, given investments that offer higher potential returns tend to be riskier than investments that typically deliver more moderate returns.

To stay aligned to your asset allocation approach over time, it’s also important to regularly rebalance your investment portfolio. For example, if the stocks in your portfolio have increased in value, you may wish to sell some and use the gains to purchase more bonds.

Diversification is a way to take your asset allocation mix to the next level. Diversification is about balancing your investments and pension plans across asset classes and within asset classes. A well-diversified portfolio can help you:

• Capture attractive gains from outperforming segments of the market. A portfolio of investments across a variety of asset classes, industry sectors, regions, management methodologies, risk profiles and goals may help you preserve and grow your assets over time. This is because having exposure to a wider array of investments can enable you to benefit from outperforming segments of the market over time.
• Reduce portfolio volatility. Diversification can help moderate short-term spikes and dips in your portfolio’s value, creating a more balanced or consistent long-term performance path. If one of your investments loses value, gains from another investment in a different sector can help offset the loss.
• Mitigate downside losses. Since money is distributed across asset classes and investment types that typically perform independently of each other, a drop in the value of any single asset can do less harm to your investment and/or your pension plan's total value. When losses are limited, your portfolio may be able to bounce back more quickly from downturns. 
• Make objective decisions. As you watch your portfolio’s progress over time, keeping market ups and downs in perspective can be easier said than done. We can help you determine when action is needed, based on your diversified, goal-based investment and retirement strategy.

Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types or classes of investment assets at the same time or in the same way (though there are often short-term exceptions, such as during the 2008 credit crisis). Swings in overall portfolio return can potentially be moderated by diversifying your investments among assets that are not highly correlated — i.e., assets whose values may behave very differently from one another. In a slowing economy, for example, stock prices might be going down or sideways, but if interest rates are falling at the same time, the price of bonds likely would rise. Diversification cannot guarantee a profit or ensure against a potential loss, but it can help you manage the level and types of risk you face. 

In addition to diversifying among asset classes, you can diversify within an asset class. For example, the stocks of large, well-established companies may behave somewhat differently than stocks of small companies that are growing rapidly but that also may be more volatile. A bond investor can diversify among Government bonds, more risky corporate bonds, high yield bonds on a short/medium/long term, to name a few. Diversifying within an asset class helps reduce the impact on your pension and investment plan invested in any one particular type of stock, bond, or mutual fund. 

Asset allocation and diversification are time-tested investment strategies that can help you achieve your financial goals. Both are important considerations to helping you enhance return potential and mitigate risks over the long term, across periods of market movement and all phases of the economic cycle. We work very closely with our clients to build asset allocation and diversification strategies tailored to their financial goals, time horizon and risk tolerance.