Does portfolio diversification really work? A financial adviser’s response …

We are confronted with several quandaries: the investor wants optimum growth at little, or no, risk; the financial adviser similarly wants to do the best for the client; and the financial adviser needs to protect him / herself from possible prosecution du

What to do? The experts, it would seem, primarily advocate a double approach as the solution: risk-profile the investor, and then allocate funds according to that outcome – whether lump-sum, premium-paying, or a combination of both; or, secondly, allocate funds into a ‘ diversified’ portfolio.

My feeling is that there is another option on the table, as the above seemingly primarily protect the adviser as opposed to the investor. Let’s analyse why I say this.

First of all, what does it mean to ‘risk-profile’ an investor? The simple answer is for the potential investor to answer ten or so questions and, voila, he / she has a risk profile allocated to him / her for the purpose of the investment. This, sadly, couldn’t be further from the truth. Anyone will tell you that you can have a conservative or aggressive approach – and everything in between – dependent on the circumstances. If the portfolio doesn’t grow in line with the expectation based on the risk-profiled portfolio e.g. the investor’s profile is ‘moderate’ and the returns over, say, a rolling 3-year period are expected to be 8% per annum, and the returns after that period are, in fact, 4% due to various socio-economic and / or political reasons, the adviser can turn to the results of the profile and say that it wasn’t his or her fault as the correct protocol was followed and growth going forward is totally beyond his / her control.

I suppose that that is true, isn’t it?

There are so many arguments to both counter as well as support this that it would be silly to try and explore each one in this article. I intend to do so at another time. My caveat, however, is not to accept such an outcome, as risk-profiled portfolios are not accurate as very many different investment and time-horizon scenarios are excluded from the survey and, of course, timing of the market, phasing-in of the investment, the amount of the investment, whether other funds are available or not, and whether the investment is premium-paying or lump-sum, additionally add to the impossible mix, and this makes the ultimate decision very difficult to determine. It is for this reason, therefore, that two scenarios exist: let the risk-profile be regarded as a core ‘guide’ and then ‘diversify’ the portfolio selection with the risk-profiled portfolio being the core. This smacks of a solid and sound investment strategy, which I fully endorse.

So, secondly, let’s look at what ‘diversification’ means. There are, of course, many answers to this but I want to specifically concentrate on the theory that expounds that a truly balanced investment portfolio consists of, more-or-less, an equal allocation towards equities, property and cash as different asset classes. (Diversification can further be expanded to include both on- and offshore exposure, as well as inclusion of bonds; also, a combination of hard and soft assets, property syndication, and containerisation, to name but a few others – for the sake of simplicity, I will not be concentrating on the latter in this article.)

For the sake of argument, let’s say that it is an accepted fact that over time – let’s say five years and longer – equities outperform property and property outperforms cash (and inflation), and let’s say that the returns over that period are 15%, 10% and 5% per annum respectively (equities, property, cash). Now I know that there are financial and mathematical whiz kids out there, but let’s also include those of us who still get by on those large R20 calculators and don’t want to get too technical with all the numbers stuff. This may sound a bit airy-fairy, but bear with me a little while longer. Let’s say that an amount is invested – whether on a regular basis or as a lump sum – and, at the end of the five-year period the amount, having been equally invested in all three asset classes, performs as history has proven (although, as we all know, past performance is no guarantee of future such returns). Thus, the return has equaled one-third of the investment at 5%, one-third at 10%, and one-third at 15%. Right? So, for those of us who are pretty basic when it comes to this type of calculation, that means that we can take 5 plus 10 plus 15 – which totals 30 – and divide it by three and, hey presto! we have an average return of 10% per annum.

Although truly very simplistic, this is what many of us do and historic returns have proven that the above is more-or-less what has been achieved, and all of our investors are very happy indeed.

Well, perhaps they shouldn’t be! Why not put all the investment into the equity portion and, instead of averaging 10% per annum, the investor will achieve a 15% per annum return, a good 50% more than what the ‘diversified’ approach would have been?

But, you may ask, what if the equity markets ‘tank’ and, after the five-year period, the growth has averaged 2% per annum – diversification would have ensured that the returns would at least have been far better than that!

The simple response is that portfolio diversification should entail the active monitoring of such investments on a regular basis and ensuring that optimum growth is achieved at all times.

This does sound like a mammoth task, but there certainly are programs out there which can track trends and, if upfront disclosures are made by the adviser to the investor that there will be regular communications regarding the investment – not just once a year – and that certain protocols will be followed in the event that markets dip by more than an agreed percentage over an agreed period of time, then optimum growth can be achieved even in volatile conditions.

The adviser is supposed to be expert and proficient in the area of investment management, but that is not always possible. Investment expertise does not come easily and demands time, education, behavioural analysis, and responsibility that not all financial planners can acquire in the short term. Diversification is definitely key to a balanced portfolio, but to only report back once a year on how the investment has, or has not, performed, is a mindset that has to be changed, especially in today’s dynamically changing economic climate. In order to aspire to a return in excess of the average, and the reason why the investor approached the adviser in the first place, are to hope that the return achieved will not be the norm but rather the achievement above the average, otherwise the investor may well have managed the funds on his or her own. And, in order to do that, an experienced, responsible, caring and investment-savvy financial adviser can add additional value when managing your investment portfolio over and above the minimum requirements of mere risk profiling and diversification.

Ensure that your portfolio is not just diversified, but actively managed by a qualified, certified and accredited financial adviser today.