Reducing risk through diversification
There are different approaches to asset allocation; risk targeted multi-asset investing is one such approach to investing that has two basic goals: to generate returns while managing risk.
Ask investors what benefits they want from their investments and they are likely to say ‘high returns with low risk.’ Risk tolerance, how much risk an investor is willing to bear, is one of the most important determinants of personal financial decisions. Some people are quite comfortable with the ups and downs of the market, while others lose sleep when their investments fluctuate in value.
One way to balance risk and reward in a portfolio is to diversify across investments which do not experience positive and negative returns at the same time. Economists often say ‘there is no such thing as a free lunch’, yet portfolio diversification is perhaps the one exception to this adage. Diversification allows investors to reduce portfolio risk without sacrificing expected return, or to increase expected return without accepting more risk.
The rationale behind diversification is that the prices of different assets may not move in tandem because their value is determined by different factors. Negative movements in one asset will be offset by positive movements in another asset. The more the two assets move in opposite directions, the greater the benefit of risk diversification. Investing across a broad range of instruments, sectors and regions whose value may not change at the same time, or move in the same direction, allows investors to smooth out the inevitable market fluctuations.
An important consideration is how to get the right mix of assets, and to keep in mind that the mix may also change over time. Several academic studies point to the fact that asset allocation, the decision of dividing an investment among different asset categories, is responsible for most investment gains over the long term.
There are different approaches to asset allocation; risk targeted multi-asset investing is one such approach to investing that has two basic goals: to generate returns while managing risk. The Friends First Magnet and Compass ranges of risk targeted multi-asset funds invest in different asset classes such as equities, bonds and property as well as alternatives including currency, commodities, offering a completely diversified portfolio in a single investment.
Each fund is constructed to achieve the maximum expected return that can be obtained for a given level of risk. Risk in this context is defined as volatility: the amount of uncertainty about the change in the value of an investment. The funds are designed to make it easier for individuals to diversify their investment across a wide range of assets, in a way that matches their risk tolerance.
Friends First’s approach to managing multi-asset funds is anchored in a methodical process that evaluates a range of potential portfolio combinations to derive the optimum expected asset mix for a specific volatility range. The key factors affecting asset classes are assessed with the aim of combining assets in an effective way. Each portfolio fund is regularly monitored and the underlying investment mix is periodically restored to an allocation consistent with the fund’s target level of risk.
Challenges as well as opportunities abound into today’s financial markets; in an environment of extraordinarily low yields investors are hard-pressed to meet their investment objectives without taking on more risk. Multi-asset investing alone can’t ensure a profit or guarantee against the possible loss of capital, particularly in the short term. Over longer periods, however, as fundamental conditions drive the price of assets in different directions, investors can really gain from the benefits of diversification.
The views and opinions expressed in this article are those of the author.
