Uncertainty and the Role of Diversification

Whilst markets have recovered some of these losses, values continue to fluctuate daily. In the UK there are concerns about how the continuation of conflict will drive inflation in a low growth environment – a phenomenon known as ‘Stagflation’.

The UK is fortunate to be insulated from the direct human consequences of conflicts such as that in the Middle East. At the same time, it’s understandable to be concerned about how the current global context can affect the value of our own investments. While market risk and volatility are unavoidable byproducts of investment, there are ways of helping your own portfolio withstand turbulent periods.

Cash

Particularly for those drawing on their investments, your portfolio should incorporate a cash reserve equivalent to at least two years’ worth of expenditure. Investors should accumulate and maintain this reserve by moving money into cash within the portfolio whilst markets are favourable. During unfavourable times the cash is available to fund retirement expenditure, negating the need to disinvest whilst valuations are depressed.

Drawing on investments during a period of low returns can accelerate capital depletion through a process known as ‘pound cost ravaging’. It sounds horrible but can be avoided with appropriate planning.

Diversification

Once the cash reserve has been accounted for, the broader, growth portion of the portfolio should be invested across a range of different asset classes. Aside from cash, the main asset classes are equities, government bonds, corporate bonds, property, commodities and alternatives.

The proportion of your own portfolio allocated to each class is determined by your attitude to risk. Equity is a higher risk asset class with elevated growth potential but simultaneously it’s prone to downside risk during volatile periods. Risk averse investors would only hold a small proportion of this asset in their portfolios.

By holding a diversified spread of asset classes within a portfolio, it is hoped that any fall in the value of one class can be offset by more resilient performance or even gains amongst the other asset classes held.

Intertwined with the principle of diversification, is that of correlation. A well-diversified portfolio would hold a blend of lowly correlated assets, which react differently to different market conditions. This approach is not foolproof. Equities and bonds have traditionally been regarded as lowly correlated assets.

However, the disastrous fallout of the November 2022 Mini-Budget and resultant rises in interest rates, as well as the conflict in Ukraine, created an environment where both asset classes suffered.

Sectors & Geographies

The portfolio’s integral asset classes should be diversified further across a range of sectors and geographies to provide an additional layer of resilience.

At present there is speculation about the Artificial Intelligence (AI) Bubble. The release of ChatGPT in November 2022 is regarded as the point in which AI entered the mainstream consciousness. Investment in the technology has subsequently accelerated since.

Fears of a bubble are predicated on the fact that AI is a technology in its infancy. There are unanswered questions about the value of some of the ways in which the technology is being used, with concerns about the environmental impacts of the datacenters that are needed to power AI-based tools.

In the context of financial markets, the ‘Magnificent Seven’ refers to a group of United States’ based technology companies that have grown rapidly in recent years – Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla.  They now represent close to one third of the entire valuation of the Standard & Poor’s 500 – the United States’ main index.

The potential for a downturn in the fortunes of these companies highlights the importance of diversifying your portfolio across a broad range of sectors and regions, not only within the United States but also across Europe, the UK and Asia, helping to spread risk and capture opportunities across the global economy.

Multi-Asset Investment

Colmore Partners’ approach to creating well-diversified portfolios for clients is based on the use of multi-asset investment funds. In conjunction with a third-party investment specialist, Asset Intelligence Research, we have built a matrix of sixty investments funds from approximately twenty managers. These are subdivided by investor risk profile.

As the name suggests, a multi-asset fund holds a diverse blend of asset classes which provides diversification, extending across sectors and geographies. Our investment blends comprise funds which adopt a combination of active and passive management approaches.

Subject to certain parameters and in accordance with the fund’s risk mandate, the manager of an actively managed fund has discretion to buy and sell assets within the fund to maximise growth opportunities and provide downside protection. These funds tend to incur higher fees but can prove valuable during volatile periods.

Passively managed funds are comparatively lower cost. Their asset allocation will tend to mirror market indices, and it therefore remains largely unchanged over time.

Active and Passive strategies have historically proven themselves in different market conditions. By blending approaches in this way, it is hoped that we can incorporate another layer of diversification into client portfolios.

Closing

We hope that you have found this article informative. Please do not hesitate to get in touch with your planner if you wish to discuss any aspect of it further.

 

Colmore Partners is an Appointed Representative of Best Practice IFA Group Limited which is authorised and regulated by the Financial Conduct Authority, the registration number is 223112.

This article does not constitute tax, legal or financial advice and should not be relied upon as such. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. For guidance, seek professional advice.