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Mark Harries: Diversification will be key to riding out volatility

Diversification will be key to dealing with the expected market volatility caused by central banks starting to unwind quantitative easing.

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New Bank of England head honcho Mark Carney appears to have learned some lessons from his counterpart at the Federal Reserve. Carney’s provision of forward guidance, which accompanied the latest inflation report, marked a significant shift in how Bank policy is communicated.

Giving such guidance is supposed to promote stability, allowing businesses and investors to plan for the future, Carney also presumably hoped to avoid the kind of volatility to which markets have been subjected since Ben Bernanke first uttered his intentions to start tapering monetary stimulus measures.

As we saw, markets did not react well to Bernanke’s announcement. Equities tumbled and government bond yields surged. It appeared that investors love their fix of monetary stimulus more than they value real economic progress. It took another, more reassuring bout of forward guidance from Bernanke to persuade investors that quantitative easing was not about to be choked off altogether.

July’s subsequent market rebound was as rapid as June’s descent. The FTSE 100 is now not far away from May’s peak and several global markets have recouped all of June’s losses.

Hopefully central bankers have learned a lesson but it is important to remember that the nascent global economic recovery has a long way to go. Further swings are likely, even if they are not caused by monetary policy pronouncements.

Unless investors are gifted with remarkable foresight and have the ability to make rapid asset allocation switches, it is all but impossible to make money out of these wild market gyrations. Unfortunately, most investors do not possess these attributes.

So what can be done to protect against such sudden market movements?

In the current environment of volatility, the importance of diversification once again comes to the fore. It has been easy to forget the benefits of a well-diversified portfolio over the last year or so, as diving headlong into equities or corporate bonds has served investors well.

Diversifying a portfolio cannot deliver absolute freedom from risk but it is possible to smooth returns and help protect capital by mitigating the effects of a downturn, while capturing the market’s upside.

We have been attempting to do this for a number of years in our Diversity Fund. One of the most important lessons we have learned is that to produce reliable returns year on year, you must diversify, while sticking with those managers that have the most experience and have managed money in all market conditions.

Furthermore, achieving the best risk-adjusted returns is not just about picking the top performing fund in each sector but about combining the right funds with complementary characteristics. By doing so, it is possible to protect against market falls and smooth returns in a consistent, risk-efficient manner.

It is interesting to recall that not long before this rally started, some commentators were heralding the death of equities. As the last few weeks have proved, reports of their demise have once again been greatly exaggerated.

However, these events serve as a valuable lesson. Despite the recovery, investors do not like to see the value of their capital lurching around in such an unpredictable fashion. The trend towards diversified investment solutions is therefore likely to continue apace.

Mark Harries is head of manager selection at Scottish Widows Investment Partnership


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