When a Spread of Risk Means More Risk
As I suspect most people do, I have just left my investments in the hands of my adviser and have hoped all will be fine, but every year, when the valuations come through, I can’t see how on earth my adviser is paid so much for doing so little.
It seems I just go up and down with the market and have no real spread away from risk. How do you do it?
It’s worth remembering that the potential for gain always matches the potential for loss; and if it’s safe under the mattress the upside potential is just as horizontal.
What the reader is asking here, however, is how you can spread your money across different areas to reduce risk. As an example (and put simply) you might choose to buy shares in a company that makes ice cream and to diversify, you may well choose a company that makes umbrellas.
In ‘money speak’ they call it negative correlation, but it simply means that if something pretty weird is happening (sunshine) you will lose on your umbrellas but gain on the diversification into the ice cream – I did say it was put simply…
Most investments I see have little or no diversification and, as I said, are left to the randomness of markets. Easy come, easy go.
For the benefit of readers, I called the above reader to find out what her real concerns were and she said she had been told to invest into a property fund, a fixed interest fund (corporate bonds are effectively loans from you to companies) and some overseas and UK equities (stocks and shares). That seemed all in reasonable order as in mathematical terms, property and fixed interests are an excellent diversifier from equities.
The following is a bit ‘sciency’ but if all of the above were correlated together, they would act the same way – so a bit like buying Wellington boots shares and umbrella shares.
If, however, they were negatively correlated that should give you downside protection.
Upon closer study the reader hadn’t been advised to buy a property fund, she had been advised to buy a form of property fund, a common mistake, and had in fact purchased a real estate investment trust (REIT).
A REIT is a spread across a range of shares in property companies, so you are effectively E22-275buying shares. A REIT has a 62% correlation to UK equities and a 68% correlation to overseas equities, effectively showing why her money was simply rising and falling with the market.(1)
Worse still, in difficult markets a REIT can fall by more than the stock it is invested into which really is a bad day at the races.
Upon even closer inspection, the lady had also been advised to spread her corporate bond money across lots of different funds which is virtually pointless as there aren’t really an abundance of quality corporate bonds out there. The idea is that each fund manager buys the range of fixed interests in the market to achieve the best returns.
However, the investor who spreads across many funds will simply finish with a spread across many of the same corporate bonds. Where is the diversification in that? – Bad day number two at the races.
A good Independent Financial Adviser will spread your capital across a range of different funds and across all the correct sectors.EVP-100 Furthermore, an Independent Financial Adviser who is a specialist with investments will also be able to focus on who the best managers are for each area.
So for example, who is offering the best UK companies spread, the best UK fixed interest, overseas equities, property and cash spread.
Each year as your investment grows they should re allocate your capital by taking the gains and realigning across the other assets, for example.
Few financial advisers are actually specialised in investments so be sure to choose one who is aptly qualified and of course independent.
Source(1) Lipper
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