The only investors who shouldn't diversify are those who are right 100% of the time.” – Sir John Templeton.
By their nature, all financial markets are cyclical. Equity markets are rising while bond markets may be falling or the European market is up while the Asian market may be down. Investors are frequently tempted to react and try to anticipate what the markets will do next.
History has shown that even the most experienced investors cannot reliably time the market. This is the major factor leading to the widespread acceptance of diversification as a strategy for meeting investment goals through complete and multiple market cycles.
Yet, by understanding how the various economic cycles affect the financial markets, and how asset classes typically behave during different stages of bull and bear markets, investors can make the best choices based on their investment goals. Of all the choices an investor must make, diversification is one of the most important.
The strategy of diversification was formalised some 50 years ago to help investors meet their investment goals while managing the risks inherent in the market. It is not prudent to put all your investment eggs in one basket – unless you are able to pick the right basket.
Diversification can be applied in two ways – at an asset class level and at a geographic level. The economic clock depicts a simplified, typical sequence of events that can influence the value of any given asset class during an economic cycle. The clock is a composite of individual economic indicators and each stage tends to be the result of a preceding economic condition.
Unfortunately, the duration and magnitude of these cycles can only be known retrospectively, and may vary greatly from country to country, and the economic clock is always clicking. When applied to equity investment, the economic clock also has a profound effect on which type of stocks perform well in different market cycles. The table above uses the US market to illustrate this – in 1999, small-cap growth stocks were the best performing asset class with a rise of 43 per cent but just one year later, in 2000, they recorded a fall of 22 per cent against a small-cap value stocks rise of 23 per cent.
The US has the biggest equity market in the world, representing over 50 per cent of world equity market capitalisation. It seems to be an obvious conclusion that the US should form a significant component of any investors diversified equity portfolio but this is rarely the case. In the UK, investors have traditionally focused on their domestic market and often end up having over half their eggs in just one basket. A UK investor's typical “balanced portfolio” may have well over 50 per cent exposure to the UK and less than 10 per cent exposure to the US.
By minimising exposure to losses in any individual asset class, diversification of assets seeks to produce desired returns with less fluctuation in the value of the overall portfolio. By spreading investments among several carefully chosen asset classes, investors can increase the probability that, while one sector decreases in value, others may rise. Investors may forgo the possibility of occasional spectacular gains in order to achieve greater consistency and reduced downside exposure.
The process called asset allocation helps diversified investors maintain discipline and focus. Timing the market becomes unnecessary, as retaining a relatively stable portfolio mix can lead to better risk-adjusted returns over the long term.
Investors may assemble a portfolio that is best suited to their needs by balancing risk tolerance and return objectives. As the markets move through their cycles, investors can carefully and strategically reallocate the mix to maintain the optimal diversification for their objectives.
During various stages in a typical bull-bear market cycle, certain asset classes tend to perform better than others or offer less risk or volatility. The goal of diversification is to assemble the right mix of investments using assets and classes that provide the desired balance of risk and return and then to modify that mix carefully as the market moves from one stage to the next. For most investors, a long-term perspective is essential.
Reallocating assets is an individual choice, made in conjunction with the investor's financial adviser.
When considering changes, key questions that should be asked include:
Should existing assets in a portfolio be maintained, while directing new subscriptions toward other funds or asset classes?
Does switching complement long-term savings objectives and the asset allocation model?
Has the investor's lifestyle or personal situation changed?
“To avoid having all your eggs in the wrong basket at the wrong time, diversify.” – Sir John Templeton.
Sir John Templeton has retired and is no longer involved in the investment decisions made by the organisation he founded. Templeton fund managers, however, still follow the investment principles he laid down. Today, Templeton is part of Franklin Templeton Investments, a worldwide investment group with over £180bn under management (as at December 31, 2003).