One of the most common questions we get asked is why portfolios own some assets that have risen a lot – and some that have not. Surely, we should be investing everything into the assets that rise the most? The key to understanding why we do this is the concept of risk and diversification. With this in mind, George Square Financial Management explains how investment diversification can help you hit your financial goals.
At George Square Financial Management, our investment portfolios are designed to make you the most money possible for the level of risk you are comfortable with. In doing this we enable your portfolio to have the highest probability of reaching your goals.
So how does this work?
The analysis of over 100 years of returns can lead us to the conclusion that risky investments, such as shares, tend to rise more than safer investments, such as government bonds, over the long term.
However, we also know portfolios perform better overall if we limit how much they lose in the difficult periods. When risky assets like shares go wrong, they can go really wrong – losing up to 50% in the most extreme circumstances. If we are able to limit these losses in the hard times, this increases the chance of an investor reaching their real-world goals, even if it means the portfolio going up a little less in the good times.
Consider the best performing stock market in the world for the last ten years – the US stock market – in comparison to a diversified medium-risk portfolio with George Square. We can use modelling tools that look at thousands of different possible outcomes for these investments in the next ten years, known as stochastic modelling, to show the range of possibilities that could lie ahead.
The modelling shows that, in some scenarios, such a portfolio would return more than 200%, but in other scenarios it falls by as much as 50%.
In contrast, the path that a diversified medium-risk portfolio might take is far less extreme. Though it’s far less likely that you would return as much as 200% in this scenario, your chance of losing more than a small amount of money is low.
When the two scenarios are examined together, the diversified portfolio is a far safer place to be than at the potential extremes of the undiversified portfolio invested only in US shares.
Investment diversification: key points
Investment diversification requires owning some assets that are designed to rise when other assets are falling. This means that, when you look at your portfolio, you will always see some assets doing better than others – this is how it is supposed to be.
Diversification works when we set realistic goals and know that if we reach them, we will have had a good investment outcome. Expecting unrealistically high gains without any risk will always result in disappointment.
Diversification also means that you should expect your portfolio to be doing better than the stock market when times are bad, and slightly worse when times are good. But ultimately, this is what gives you the highest probability of reaching your long term goal. You can read more about the key benefits to having a well-diversified portfolio here.
Intelligent investment advice
At George Square Financial Management, we provide intelligent, creative investment advice to individuals, trusts, families, charities and businesses. We excel at analysing your existing portfolio and assessing how this can best be optimised – often in a more tax efficient or cost-effective manner. We can also guide you through tough financial climates such as during an economic downturn.