Asset Allocation and Diversification in Everyday Investing
Investments will rise and fall in value from time to time.
The goal is to ensure the long-term rise is at the optimum level for our individual risk position. “Slide” Goal = optimise the long-term return. In seeking to optimise long-terms returns we have to be very wary of losses and particularly the three “S’s”.
Investors need to avoid these type of situations. Series of quick flash graphs appearing showing different loss scenarios over time due to steep loss, sudden loss, and sequential loss – typically where the line is now a descending one. The reason why investors should manage their positions aiming to avoid steep or sudden or sequential losses is because they devastate long-term returns.
Think of cycling.
It takes a lot more effort to cycle up a hill than down a hill. Cyclist free-wheeling down the side of the hill – followed by another image of one going 1 mile per hour up the other side of the hill. If you invest and lose money, the steeper the loss, the greater the recovery required. It is harder to get back to the starting point. So if you lose 10% of your investment value, you need 11% return to get back to the starting point. If you lose 25% of your investment value, you need 33% to get back to the start and 50% requires a 100% future return. The steeper the loss, the higher the recovery required. Losses that are sudden, leave no time for investors to react or come at a bad time when investors do not have recovery options. Sequential losses are maybe smaller but they happen for a few years at a time, this is not great for any investor situation, but especially bad for investors who require income from their investments.
Rule Number One of Investing is therefore all about managing the downside risk. Rule #2 of Investing: See rule #1
All investors should therefore arm themselves with the best risk management tools available. However, unfortunately, there is no magic wand. A person with a magic wand that disappears or falls to the ground. The best risk management tool available to most investors is to diversify and to do so skilfully.
Diversification = the best way to risk manage investments.
Diversification is the application of spreading your investments across different assets, with different risk levels and finding the right percentage amounts for each part. And then managing this on an ongoing basis. It’s the eggs in baskets analogy. Investor images with eggs and baskets in front of them. High Risk investor with eggs all going into one basket. Managed Risk Investor with lots of eggs and lots of baskets. The eggs and baskets have to represent the different asset types and different risk levels. Plus the percentage in each.
What is an “asset type or asset class?”
There are lots of different asset types and they have different levels of risk. How you split your amounts into each basket will determine your overall risk position. It is this management of the eggs into the basket that represents the asset allocation approach and the principles of diversification. It is how skilfully this is done that will determine the long-term outcome. Skilled diversification is the best way to risk manage your investments position.
How do you know what amounts to allocate?
Work with a skilled asset allocation manager who can help you determine this for your risk position. Show a professional person working with the investor helping to work out the percentages in each basket. Very importantly, this should be reviewed, renewed and rebalanced over time as circumstances change and results appear, because this will impact the percentages that are best at those different points in time. This is what we do and this is how we work with our clients to strive for the optimum position and to help them with exceptional investment experiences.