The merits of diversification - Veterinary Practice
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InFocus

The merits of diversification

Andrew Neale stresses the importance for investors of having a good spread to minimise risks.

I’M sure you will be aware of the expression, “Don’t put all your eggs into one basket.” The origins of this are hard to find, although my favourite theory comes from a legend when King William II of England had requested hard-boiled eggs for the festival in anticipation of the birth of his second daughter.

A courtier had consulted the Bishop of Sussex the night before the birth. Subsequently, the bishop then prophesied that he should perhaps separate all the eggs to be served at the birth ceremony into different chardons, or baskets, or there might be a catastrophe at the birth ceremony.

Unfortunately, the courtier failed to heed this warning and subsequently when a servant knocked over a chardon, all the eggs were lost.

Now you may be wondering what relevance King William II and the Bishop of Sussex have to the current financial markets –which currently lie deflated following a recovery of sorts at the start of the year.

The effects of a hung parliament, a general lack of investor confidence and the BP oil spillage catastrophe have taken their toll on the markets and have wiped out most of the growth received in the first quarter of 2010. However, I am hoping to use this idiomatic phrase, although some would prefer cliché, to help investors appreciate the importance of diversification within their portfolios.

A gamble

Any sort of investment is a gamble. However, diversification is useful when attempting to minimise the risks posed to your investment portfolio by the different asset classes of investment.

Before we start, it is imperative to understand the different types of risk and the ways in which they can affect your investment. For example, there is the risk of losing money (capital risk) – i.e. the capital value of your investment going down.

There is also the risk you do not get the income you are expecting (income risk) if, for example, a company can’t afford to pay the interest on a bond or if you have a property and there is a gap between tenants. We should also not forget the most serious of risks posed to investors, which is the risk of the company going bust and defaulting on your investment (default risk).

These risks can be reduced,but not entirely eliminated by diversification. Unfortunately, there are no risk-free investments available to the consumer, not even banks or building societies. Just ask those who invested in Northern Rock or Kaupthing Singer and Friedlander!

However, by prudent financial planning and by diversifying a portfolio through investment across a range of asset classes, in other words not putting all of your eggs into one basket, then the risk can be spread. There are two main advantages of this: minimising the impact of individual losses and spreading your investment.

Minimising the impact of potential losses

In-layman’s terms, this means that if 12 months ago you used all of your money to buy shares in BP, whose share price has fallen dramatically, you are going to have lost a lot of your money.

However, if you had used your money to buy shares in many different companies instead, and then one of these companies went bust, then this will have had nowhere near as pronounced an effect on the overall performance of your portfolio.

In an ideal situation, people would have a large deal of money to invest and therefore could invest directly into different assets in order to create a wide investment spread.

In reality, however, economies of scale force most investors into using pooled investments (otherwise known as collectives) to achieve diversity. This method is a key way to reduce the risks of individual investments falling in value (whether it is equities, fixed interest securities, property or cash-based investments).

Spreading your investment

This is a fundamental part of successful long-term investing and is known in the industry as asset allocation. Put simply, asset allocation means how you can choose to spread your investments, and in what proportions, across the different asset classes in order to minimise investment risk or, in other words, how much you choose to invest in shares, bonds, property or cash at any one time.

You can also diversify within an asset class. Each asset class is made up of different types of investment. For example, some firms, such as ourselves, take this approach and set out in our asset allocation for equity holdings to be spread amongst the different equity market sectors such as America, UK, Europe, Japan and “emerging markets”, as well as featuring exposure to other types of investment such as cash, fixed interest and property.

Independent

If you choose to invest in pooled investments, it is also worth spreading your risk across different holdings too. For example, a specific fund which invests only in the satellite energy and commodity sector would, in all probability, be much more risky than a fund invested across a wide range of companies in a market, such as the European (including UK) sector.

The asset classes all work independently of each other. If one is going up, then another may be falling. For example, in the current market conditions, most sectors are suffering as a result of the global credit crunch and have fallen in value.

At the same time, however, the international corporate bond sector has risen as investors invest heavily into these fixed-interest security-based investments whose performance statistics have also benefited from fluctuations in the exchange rates and produced an attractive return for investors.

Another historic example can be seen in the period from 2000 to 2003 when many shares fell in value significantly, but at the same time the values of property, bonds and cash all appreciated in value.

Therefore, investors who had invested purely in equities would have faced heavy losses over this time period. Conversely, for those who had spread their investments across the different asset classes, the loss would have been significantly reduced.

  • The author can be contacted at: Allchurch Bailey Wealth,Almswood House, 93 High Street, Evesham, Worcs.WR114DU;telephone01386 44259; e-mail andrew.neale @abwealth.co.uk; website www.abwealth.co.uk.

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