By Freddie Lait at Latitude Investment Management | Thu, 19th October 2017 - 12:21
Diversifying your investments is easier said than done, but do it you must. In order to generate sustainable long term returns investors must do more than simply ride trends or invest in the latest exciting themes.
Choosing a variety of investments will ensure a more stable and predictable source of future returns, especially when focussing on stocks which are fairly valued, have high quality business models and strong industry backdrops.
Beyond that, investors need to consider further diversification through their asset allocation. This deserves an enormous amount of thought, far more than it often receives. Various academic studies point to the fact that more than 80% of portfolio returns come from asset allocation. Below I offer a simple way to frame the thought process and some tips for specific non-equity strategies tailored to your specific portfolio.
Behaviourally we are all loss-averse, albeit to different degrees. At Latitude, we are consciously quite risk averse and aim to construct portfolios which, under normal circumstances, shouldn't suffer worse than a 10% drawdown. And by normal, we don't mean "except for the bad bits".
We invest with the permanent expectation that there is always the potential for unforeseen events in the near future which could cause stock markets to fall 30% or more. Indeed, over the last century stocks have lost more than 30% in value roughly once every decade, and we need to be prepared for that.
Without the power of diversification, this fact would imply a target allocation of c.30% in stocks and the remainder in cash, a very unsatisfying position. A portfolio with this allocation (assuming no alpha from successful stock picking) would have generated negligible real returns in the long term, assuming average returns from equities of 8-9% versus a long-term inflation rate of 3%. We need to do better and, fortunately, we can, thanks to diversification.
William Sharpe famously proved that adding a risky asset to an investment portfolio reduces your total risk exposure provided the risks of that asset and the original portfolio are sufficiently different. It is well documented that such differentiated or uncorrelated assets (such as government bonds for example) are currently overpriced and, as such, often increase risk despite, on the surface, appearing to reduce it.
This is true for most traditional Strategic Asset Allocation models, and the much-admired balanced funds of stocks and government bonds may have had their day. However, since the financial crisis we have continued to find assets that significantly reduce the risk of our equity portfolio and incrementally add to the returns we generate. The key is to think about such assets in relation to your own portfolio, and use them tactically.
If, for example, you are worried about the effect that political uncertainty will have on your companies, owning 5-10% of gold has been shown to frequently mitigate losses during uncertainty induced sell offs.
If your portfolio of highly valued consumer staples stocks has performed well, but you are not yet willing to sell the positions, perhaps including some Index Linked Gilts would makes sense. That would offset any losses you may suffer should those stocks de-rate in a highly inflationary environment
If you are worried about a broader economic slowdown or recession, then the simplest diversifying asset will likely be conventional government bonds as rates may well be cut, driving yields lower once again and the price of these bonds higher.
We believe that diversification within your stock portfolio is the most critical place to start, but that value can also be added (both in terms of risk reduction and return enhancement) through the tactical use of non-equity investments, if tailored specifically to your portfolio.
If we return to our earlier inadequate allocation of 30% stocks and 70% cash, the above principles would instead make us comfortable investing around 50-60% of our assets in stocks, provided we have the remainder invested in diversifying non-equity assets similar to those above.
The result is a portfolio with higher expected returns, despite taking similar or even lower levels of risk. A true understanding of this alchemy is what sets successful long-term investors apart from the crowd.
Freddie Lait is founder and CIO of Latitude Investment Management and Investment Manager of The Latitude Horizon Fund.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.