View more on these topics

Cycle path

The only investors who shouldn&#39t 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&#39s 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&#39s 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&#39s lifestyle or personal situation changed?

“To avoid having all your eggs in the wrong basket at the wrong time, diversify.” – Sir John Templeton.

Note:

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).

Recommended

Keydata makes mark of innovation

Keydata Investments has brought out a guaranteed equity bond that offers investors their original capital plus a return above this when the market goes up or down. The innovative growth plan is linked to the FTSE 100 index for six years. Investors will get their original capital back at the end of the term regardless […]

Structured plan sole link is China

Structured product provider Dawnay Day Quantum is launching the UK retail market&#39s first structured offering linked solely to the Chinese stockmarket, the FTSE Xinhua China 25 index. The fund offers investors 90 per cent capital protection at maturity and 70 per cent of the growth of the index which consists of companies trading on the […]

NAO says Treasury numbers affected by lifetime limit

The National Audit Office says the Treasury&#39s estimate of the numbers likely to be affected by the £1.4m lifetime limit is only half the figure it thinks will be hit.Th NAO also says there is a “thin evidential base” for the Treasury&#39s estimate of a further 1,000 people a year affected by the limit that […]

Compensation scheme should be a safety net, not an escape route

I was disturbed to read in Money Marketing last week that Berkeley Berry Birch is letting the liabilities of its IFA firm fall to the Financial Services Compensation Scheme. Most of us seek to be professionals, providing people with the highest standards of advice and taking full responsibility for the quality of that advice. A […]

Treasury looks to address advice gap

By Jamie Clark, Business Development Manager, Royal London Hot on the heels of consultations on tax relief and pension transfers and early-exit charges comes a new investigation into the advice gap, and how this can be bridged. Ever since the new pensions freedoms were introduced, concerns have been raised about how people can get access […]

Newsletter

News and expert analysis straight to your inbox

Sign up

Comments

    Leave a comment

    Close

    Why register with Money Marketing ?

    Providing trusted insight for professional advisers.  Since 1985 Money Marketing has helped promote and analyse the financial adviser community in the UK and continues to be the trusted industry brand for independent insight and advice.

    News & analysis delivered directly to your inbox
    Register today to receive our range of news alerts including daily and weekly briefings

    Money Marketing Events
    Be the first to hear about our industry leading conferences, awards, roundtables and more.

    Research and insight
    Take part in and see the results of Money Marketing's flagship investigations into industry trends.

    Have your say
    Only registered users can post comments. As the voice of the adviser community, our content generates robust debate. Sign up today and make your voice heard.

    Register now

    Having problems?

    Contact us on +44 (0)20 7292 3712

    Lines are open Monday to Friday 9:00am -5.00pm

    Email: customerservices@moneymarketing.com