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Diversification of investments is the key to long term growth

Equities outperform other asset classes in the longer term for investors who can withstand volatility and temporary losses

Determining the risk appetite of an investor is key to determining an appropriate diversification strategy. Photograph: iStock
Determining the risk appetite of an investor is key to determining an appropriate diversification strategy. Photograph: iStock

An element of diversification is important in any investment strategy but experts agree that if you want to achieve growth in your assets over the longer term your portfolio should have a strong weighting towards equities – assuming that you are comfortable with a degree of volatility.

Changes in pension practices, meanwhile, mean that shifting out of equities into cash as you approach retirement is no longer necessarily the best strategy.

Ian Quigley, head of investment strategy at RBC Brewin Dolphin, says determining the risk appetite of an investor is key to determining an appropriate diversification strategy. There is no such a thing as a typical investor, he points out.

“It starts with individual investors’ objectives and their ability to withstand periods of financial volatility or temporary loss,” he says. “The equity markets regularly fall by 10-20 per cent and every so often there is a significant financial crisis event, which is highly likely to happen over an average investor’s lifespan. Understanding your ability to withstand those events financially and behaviourally is really important.”

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The question investors need to ask isn’t just how bad they would feel if their portfolio fell by 20 per cent or more – but whether they would be happy to stay invested instead of taking flight to safety in a more secure asset class, a move that would turn a temporary loss into a permanent one.

Quigley says that despite the inherent volatility, all the historical evidence is that equities outperform all other asset classes in the longer term so a medium-to-long-term investor should have a heavy weighting in equities if they want to optimise their return, assuming they can live with the possibility of short-term losses.

So called “dollar cost averaging”, where investors feed fixed sums into a fund on a regular basis, such as via a monthly deposit, means that they can also take advantage of both peaks and troughs to buy fund units at different prices, reducing the impact of volatility.

Ian Quigley, head of investment strategy at RBC Brewin Dolphin
Ian Quigley, head of investment strategy at RBC Brewin Dolphin

“The long-term return from equities has been around 6 per cent above inflation,” says Quigley. “From a starting point of today, those returns are likely to be lower, so a yield closer to 5 per cent after inflation would be a better expectation. That might seem quite modest to some people but if you do the compounding on that it is quite powerful over time.”

History shows that holding assets in cash deposit form erodes value in the long run. Nonetheless, not every investor is comfortable with a large equity exposure, Quigley notes.

“If someone has enough assets and they want to avoid volatility and want to keep money in cash or buy a few government bonds keeping pace broadly with inflation, that may be more important to them than maximising their return,” he says.

Cash, government bonds or corporate bonds – effectively involving lending to banks, governments or companies to get a return – are all other forms of diversification with guaranteed returns, albeit modest ones. The German 10-year bond yield, for example, is currently at around 2.3 per cent – slightly less than inflation – while blue-chip corporate bonds will pay slightly more than this figure.

Property is another asset class worth considering. Real estate investment funds (REITs) are one option and have become increasingly popular in recent years. It is also possible to use pension funds to buy property directly, although investing in individual property carries concentration risk as well as the hassles associated with owning and managing property.

The timeline for investing is key, notes Niall McGrath, director in pensions practice at PwC.

“Where the investment time horizon is five years or less, capital preservation will likely be the key requirement and cash and cash-like assets will be appropriate,” says McGrath. “As the investment time horizon extends, investors can take on more volatility as the timeline allows time for markets to recover from periods of underperformance.”

The terms “risk” and “volatility”, says McGrath, are synonymous in investment strategy for many; however, accepting a level of risk is a key driver in delivering better expected returns.

“We focus on the time frame of any investment and the potential need to access the investment unexpectedly,” he says. “Where an investment can be committed over the medium to long term we highlight that, rather than short term volatility, the key risk is that inflation erodes the purchasing power of assets invested.

“In those circumstances we work with clients to develop strategies that allocate to real assets such as equities and property.”

He agrees with Quigley that the risk capacity of investors is a key issue but for investors with long-term time horizons the allocation to growth assets such as equity and property will tend towards 100 per cent.

Diversification within asset classes is also important, McGrath notes – for example, across large and small cap equities, across industries and across regions. Dealing with concentration risks has emerged as a theme in recent years due to the performance of a small number of US-based technology stocks.

The changing nature of pensions has had implications in terms of diversifying and de-risking investment funds, says Cian Morrissey of Morrissey Wealth Management.

“In the past, when someone’s pension came to maturity they used these funds to buy an annuity, and that would guarantee a certain level of income for the rest of their lives based on the fund value. So it would have been incredibly important to de-risk their pension before retirement as a fall in the value of the fund would drastically reduce the income in their retirement,” says Morrissey.

The need to de-risk should be tempered with the need for ongoing and future growth.

—  Cian Morrissey

“Now, however, once people retire and get their tax-free lump sum, the remainder is usually transferred into an approved retirement fund (ARF) where their pension continues to be invested.

“Clients are obliged to draw a minimum of 4 per cent per annum from the year they turn 61 and 5 per cent from aged 71, and the strategy should be that the investment performance surpasses this.

“Through the use of ARFs, we are typically noticing clients who started a pension at 40 with plans to retire at 65, may not be even at the halfway stage of their investment journey. Therefore the need to de-risk should be tempered with the need for ongoing and future growth.”

One option for those looking to diversification is to consider an investment fund with a multi-asset platforms, offering a combination of equities, property, bonds and cash, for instance.

“I will often advise clients to split their investment between two different life companies. This not only reduces asset manager risk but you can pick funds that are primarily invested in different sectors/locations etc, and with a different balance of assets,” says Morrissey.

McGrath says that whatever the asset class, investors should regularly engage with their advisers and review their agreed investment strategy.

“This process will allow changes to be made to reflect changes in personal circumstances or views on investment risk over time. It provides an opportunity to reflect on the performance of a portfolio and evaluate investment performance. It is also important to consider how best to ensure unnecessary tinkering is avoided, and that portfolio reviews lead to defined actions.”

In considering a diversification strategy, one thing that is clear, however, is that life expectancy has been steadily increasing over the years. If investors want to enjoy their extended golden years in comfort, their investment strategies need to take account of this and need to include assets that can deliver returns that beat inflation.