If you haven’t already heard, we’re treating you to chocolately returns this Easter! In light of this, we thought we’d give you an Easter themed crash course in portfolio diversification.
What is portfolio diversification?
The term was coined by Harry Markowitz after he published a paper entitled “Portfolio Selection.” (1) He explored the way in which investors could lower the risk of their portfolios by spreading their capital across a variety of different asset classes.
Essentially, by choosing asset classes that do not move in “lock-step” together, “higher risk-adjusted returns can be achieved.” Simply put, the more asset classes you spread your capital across, the lower the risk. The goal is to avoid putting all of your Easter eggs (i.e. money) into one basket (i.e. a single asset class). Here’s how it works.
Real life example:
Below is an example of 2 different investment portfolios. In portfolio 1, all of the investor’s capital is placed into a single asset class. In portfolio 2, the investor’s capital is spread out amongst three different asset classes.
Portfolio returns between January 1987 — December 2007
Portfolio 1 Portfolio 2 UK Equities 100% 45% UK Gilts 45% UK Property 10% Annualised Return 10.7% 10.6% Volatility (Standard Deviation) 15.6% 9.9% Maximum Loss -42.9% -18.4%
Jargon Buster: What is standard deviation?
Standard deviation is a tool used to measure an asset class’ volatility over a certain period of time. It can help determine an asset class’ risk. For example, if an asset class is providing significantly inconsistent returns, it’s unpredictable and could, therefore, pose a higher risk.
As shown in the table above, Portfolio 2, which is far more diversified than Portfolio 1, offers a significantly lower risk. Let’s take a look at each portfolio in detail:
With the Portfolio 1, the investor has decided to put all of their capital into UK Equities. The annualised return of this asset class between January 1987 and December 2007 was 10.7%, and the asset class’ standard deviation was 15.6%. As a result, the maximum loss the investor could have experienced was -42.9%. This investor’s capital is entirely at the mercy of a single asset class. As a result, if this Easter basket starts to weaken, all invested capital is at risk.
With the Portfolio 2, the investor has decided to spread their Easter eggs across three different baskets, putting 45% in UK Equities, 45% in UK Gilts and 10% in UK Property. Collectively, the average standard deviation of these asset classes between January 1987 and December 2007 was 9.9%, resulting in a maximum loss of -18.4%. In this instance, your capital may still be at risk, however, by spreading your Easter eggs across three different baskets (instead of just one) would have reduced your maximum loss by 24.5%!
Reducing Risk During Economic Downturn
Different asset classes react differently during an economic downturn. Although portfolio diversification is widely regarded as a long-term investment strategy, it is needed most during times of economic downturn. The key to diversification is spreading your capital across assets that move in opposite direction of one another during the same market forces. Your portfolio ought to include assets that don’t behave in the same way when times get tough. Essentially, when a diversified portfolio is comprised of such assets, “losses in one part of the portfolio are likely to be offset by gains elsewhere.” Stock markets, for example, have historically coped well with inflation, partly due to the fact that companies can raise prices to counteract it, which reflects in share prices. Bonds, on the other hand, may suffer under periods of inflation, as any available returns are often fixed, making them less valuable when inflation is rising. In contract, the value of gold has characteristically risen during periods of inflation, as it is viewed as “a hedge against rising prices.”
How to Spread your Easter Eggs into Different Baskets with Property Moose
At Property Moose, we recognise the value of diversification, which is why we try to provide the tools you need to build a well-balanced, diversified portfolio.
- Different products
We offer a variety of products, each with a different risk/reward ratio. In regards to asset performance during an economic downturn, we have previously calculated the way in which the Property Moose Mortgage could have offered a reward that was significantly higher than other investments during the recession of 2007. Including assets that hold a negative correlation with one another in your portfolio can help mitigate the risk of such economic downturn. Within our property investment opportunities, we also list a range of mixed-use, HMO (House of Multiple Occupancies), buy-to-sell opportunities, buy-to-let and private equity developments.
- Different regions
Diversification shouldn’t simply apply to the asset classes you choose, but it should also apply to the different regions you invest in. In a similar regard to certain asset classes, regional house prices do not move in lock-step together. We try to source our properties across different areas of the UK, with recent investment opportunities in St. Neots, Cambridgeshire, and Wigan, Greater Manchester.
One of the most exciting things about diversifying your portfolio with Property Moose is that you only need £10 to invest in any of our opportunities, hopefully allowing you to spread your capital across a variety of different investment opportunities!
Written by Jenna Kamal
Disclaimer and Legal
Property Moose does not provide any advice in relation to investments and you must rely on your own due diligence before investing. Please remember that property prices can go down as well as up and that all figures, rates and yields are projections only and should not be relied on. If in doubt, please seek the advice of a financial adviser. Your capital is at risk if you invest. This post has been approved as a financial promotion by Resolution Compliance Limited.
Property Moose is a trading name of Crowd Fin Limited which is an Appointed Representative of Resolution Compliance Limited which is authorised and regulated by the Financial Conduct Authority (no: 574048).
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