Investments: Are you a hobbit or a dragon?

DIVERSIFICATION is the single most important discipline of long-term investing, yet many investors pay a high price for overlooking it.

Markets may be rallying now, but the next slide is never far away – and that’s when making the decision to diversify comes in.

It was billionaire investment guru George Soros who observed: “Markets are constantly in a state of flux and money is made by discounting the obvious and betting on the unexpected.”

But the fact is most of us are risk-averse and want to spread our investments in hope of minimising the downside. But what does this actually involve, and how can we put such a balance approach into practice?

What constitutes a well-diversified portfolio largely depends on what type of investor you are. Diversification for one person could mean a portfolio jam-packed with equities that are spread across different sectors – miners, banks, industrials or in different geographical locations. For another, ultra-cautious investor, it could mean using a spread of banks for large cash deposits.

Indeed, in the mythology of risk-taking, some of us are more hobbit-like than Smaug like, playing for small stakes in the hope of big returns, but not adverse to adventure. Unlike the larger behemoths, sitting on their cash piles (however obtained) and seeking to accrue more by old and trusted means.

So as the 2013-14 Isa allowance comes into play, what does it mean to truly diversify and what sort of mix of assets should you have?

RATING YOUR RISK

Before constructing an investment portfolio, the starting point should always be to devise a financial plan based on your circumstances and objectives. Ask yourself a few questions:

• What exactly are you seeking to achieve?

• Do you favour capital growth, income or a combination of the two?

• Over what time-frame do you want to invest?

• What is the size and shape of your existing investments?

• What is your current tax status?

These are all important factors to consider. Your attitude towards investment risk is the next key area. Investment terms such as “moderate” or “cautious” are much too vague. An equity broker, for instance, might equate a cautious approach with a portfolio of developed market blue-chip shares, whereas to many investors it might mean remaining in cash-like investments where the risk to capital is minimal (though the risk of inflation eroding your spending power is higher).

Financial advisers often use some form of risk profiling tool to arrive at a risk rating for an investor and provide them with examples of what a portfolio based on that risk rating could look like. This often illustrates the split between defensive and growth investments, the expected volatility and historic maximum losses. These tools help an investor to understand the investment risk they will be exposed to and the potential rewards.

Once you’ve worked out your risk appetite, the investment process can begin. Diversification should be the cornerstone of all action taken.

Diversification by using portfolio building blocks (the main ones being cash deposits, fixed income, property, equities and alternatives), each of which are themselves diversified, creates an asset allocation mix that can be altered to suit each risk profile.

Getting the asset mix right for your given risk profile is the key driver of performance: research shows that around 90 per cent of returns is driven by asset mix rather than the choice of stock or fund.

The main asset types typically perform differently in varying market cycles; understanding the correlation between asset types is critical when balancing risk and projected returns.

For instance, property and equities tend to show a strong positive correlation and a portfolio containing these two asset classes would typically perform well in an equity bull market.

However, the reverse is true when equity markets fall, so it becomes prudent to protect against downside risk further diversification using negatively correlated assets (where, very broadly, when one goes up the other goes down).

By adding fixed income – which is typically negatively correlated with equities – you could achieve a much more diversified portfolio to help control risk and produce more consistent returns. Diversification can be increased further by adding so-called “alternative” asset classes. An example would be to add gold to a primarily equity and fixed interest-based portfolio.

Further diversification can be achieved within each asset class by selecting a wide range of investments which helps spread risk further. For example, the equity portion of your portfolio might consist of a spread of individual stock or, more commonly, a basket of collective investments. By selecting collectives with different management styles – passive and actively-managed funds – you can achieve further diversification.

l sO WHAT COULD YOUR ASSET MIX LOOK LIKE? This, to a degree, depends on your wealth manager. However, it is fair to say that a low-risk investor who is sensitive to investment volatility and is prepared to trade the prospect of higher growth for the certainty of more modest predictable returns would typically have a much greater allocation to cash and fixed interest at the safer end of the risk spectrum – so government gilts in developed markets, such as the UK. Higher-yielding bonds come with a bigger yield but the risk of default and, therefore, greater potential capital loss.

Other likely investments are diversified property funds, again to provide an income focus, and a smattering of defensive equities. A typical asset split might be 5 to 10 per cent in cash, 40 to 50 per cent in fixed interest, 10 per cent in property and alternatives and just 30 to 35 per cent in shares in sectors that tend to weather economic downturns, such as pharmaceuticals and tobacco stocks.

As the appetite for risk increases, the proportion of growth assets rises. A more adventurous investor will typically include a greater allocation to equities, firstly in developed markets but tending towards specialist sectors and emerging markets for higher risk takers. An investor near the top of the risk scale might have less than 5 per cent in cash, up to 10 per cent in fixed interest, 20 per cent in alternatives and up to 70 per cent in equities with an emphasis on growth.

A middle-of-the-road investor will, clearly, have a portfolio that sits somewhere in between these two extremes. This would typically comprise 50 to 55 per cent in shares with an even balance between growth and defensive investments, up to 5 per cent in cash, 10 per cent in alternatives and property and 30 to 35 per cent in fixed income.

• Stephen Hall is a chartered financial planner at Edinburgh-based Cornerstone Asset Management.