How can I diversify my investments to remove risk?

I have spoken to my bank and they have told me to diversify my investments to take risk out. Can you explain how that can be done?

So much emphasis is placed on diversification of investments but, in fairness it is a very difficult task.

For the insurance companies who offer their managed, or managed cautious funds, this may simply mean that, come what may, you still invest your money with them and they get their cut. Whether your investment is up or down is not relevant, at least you were diversified!

For the financial adviser it may mean a spread across a wide range of funds that can prove risk is reduced.

For the customer I suspect it means you maximise returns and minimise risk and outperform inflation.

Warren Buffet, however, believes diversification is for those who have no idea what they are doing.

I can understand what he means. If you believe interest rates are rising for example, it’s easy to see why you might avoid some fixed interests. Moreover, Buffet’s views are that you should know your subject so well, that diversification is not required, i.e. buy what you know will go up, don’t buy what will go down. Simple I suppose.

For most of us lacking Mr Buffet’s skill, we have to rely on the fact that diversification is required and of course that brings with it huge potential to get things wrong.

For me, diversification equates to that old model of ‘negative correlation’ i.e. buying a perfectly good Wellington boot company and a perfectly good ice cream company. In normal conditions both will perform well, but in extreme conditions one will rebalance the other.

I must admit to being more than humoured by a recent report I read, where an adviser had recommended a customer to diversify their holdings. The customer was advised to invest in a with profits bond and technology. What a great idea – lose money or just watch inflation batter the remaining capital!

The backbone of most diversification models means you simply spread your cash across a wide range of sectors and assets such as property, fixed interests, overseas equities and UK equities for example. This is easy to get wrong, and another recent report I saw was ultimately flawed in the fact that the attempt at negative correlation failed. Boy had it failed.

Property is often seen as a diversification to equities and it is.

Whilst this may be a little scientific, bear with me. When we are measuring diversification we measure via a term called correlation coefficient. Effective diversification comes when the correlation coefficient is a low perfect positive, or perfect negative correlation to another asset class.

UK property as an asset for example has a 22% positive correlation to UK equities, 19% to overseas equities, 10% to fixed interest and 23% to global Real estate investment trust (REITs). All very good. This is clearly a good diversifier from most of the other asset classes. Overseas equities have a 90% correlation with UK equities and a 62% correlation with REITs showing a high positive correlation which is not good for effective diversification.¹

The report I read was interesting in that the adviser had chosen a REIT and also Aberdeen property share (a spread of property shares) as a property diversifier with UK equities. A REIT and also the shares have very high positive correlation which effectively means there is no diversification at all – a point they will now understand very clearly because of the activities of the last few months. It is only the property assets as opposed to property shares that provide diversification.

In any event, asset allocation models are not prescriptive in diversifying. They are only as good as your ability to continue to use historic data regarding the economy for forward planning. For example a basic understanding of the economy would have directed you to offload property and fixed interests some twelve months ago. Easy isn’t it?

Source: 

1. Lipper

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The value of shares and investments can go down as well as up

Tags: diversification, equities, investing, investments, REITs, risk, Warren Buffett

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