December 2015
Schroders
Diversification Explained
Why is
diversification
important?
One of the most important aspects of successful investment is diversification. This can be simply
expressed as ‘don’t put all your eggs in one basket’.
Diversifying investments across a number of different assets is important because it can help to reduce
the risks of investing. By risk we mean both that of losing money and that of experiencing volatile
returns (extremes in the levels of return over time, in other words a ‘bumpy ride’).
Diversification works because not all assets react to the same conditions in the same way. For
example if the weather in a year is better than expected we would expect an ice cream manufacturer
to sell more ice cream but an umbrella seller to sell less umbrellas – and of course the opposite
would be true in a year with poor weather. In more technical terms, the likely returns from these two
companies are said to be uncorrelated.
This very simple analysis can be used to create portfolios that begin to manage risk, as investing in both the
ice cream manufacturer and the umbrella seller together should cancel out some of the fluctuations
from each business.
This idea of investing savings in more than one company is well established which is why most members
of defined contribution pension schemes invest in pooled funds which have investments in many
different companies, for example a UK equity (i.e. shares) pooled fund.
How does
this affect
my pension
savings?
Most defined contribution pension schemes use exactly the same concept to reduce the risks
associated with investing in a single stock market (for example the UK stock market).
This is most commonly done by investing pension savings into funds that mix overseas stock markets
with the UK stock market.
Historically the returns from a stock market have been primarily dependent upon the underlying
economy of the country they represent. Consequently they have offered diversification benefits to
each other, similar to those we saw from our ice cream and umbrella seller example.
As the world has entered a greater period of financial harmonisation brought about by globalisation the
diversifying benefits of investing in overseas stock markets have been substantially reduced. In fact we now
find ourselves at a time where the major stock markets of the world react in a similar manner to events.
Power of diversification example
The chart below illustrates the strength of the relationship between UK Equities and US Equities. It
is evident that the strength of the relationship between these markets has been increasing over the
period measured. This means that any event which may affect one of the markets will also have a
stronger impact on UK Equities than it would have in the past.
Growth in the strength of the relationship between UK equities and US equities
Strength of relationship
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
1995
1998
2001
2004
Strength of Relationship between UK and US Equities
2007
2010
Trend line
2013
2015
Time (years)
Source: Schroders, Datastream. Lines represent the strength of relationship between UK Equities and US Equities over rolling 5 year
periods since 1 January 1995 to 1 December 2015 using monthly observations. A trend line has been added for emphasis. Indices
used: FTSE All Share and S&P 500 Composite.
Schroders Diversification Explained
What can I do
about this?
The analysis above shows that investing in different equity markets is becoming a bit like investing in a
number of different ice cream sellers. When the sun is shining they all sell a lot of ice cream and when
it is raining they all sell less ice cream.
One solution to this changing behaviour of world stock markets is to recognise that they are
increasingly likely to move in the same direction and then simply accept the consequences. These
consequences are that the good long-term growth that investing in equities can generate comes with
a bumpy ride; that there may be relatively long periods where equity markets deliver negative returns
or fail to keep up with inflation.
A sensible alternative is to find other types of investments that can generate similar long-term positive
returns as equities but that also react differently to equities to the same events. A good example of
such an asset class (i.e. asset type) is commodities (for example metals).
If interest rates in the UK rise, then after paying household bills like mortgages, people will have less
money to spend on other things. Consequently, if investors expect interest rates to rise, we might
expect demand for company shares to fall, as the profitability of these companies depends in large
part on consumer demand. This could then result in falling equity markets.
In these circumstances demand for other ‘safe’ assets may increase. One such asset is gold, as
investors often see gold as a good way of protecting their investment in times of market turmoil. This
may cause gold prices to rise. Therefore, we would expect a portfolio containing equities and gold to
perform better than a pure equity portfolio if the outlook is for interest rates to rise. This is because the
gains from the gold assets would be expected to partially compensate for the losses from the equities.
Gold is just one example of the types of things found in a commodities fund. Other commodities,
such as energy, agriculture and other metals, react in different ways to equities as well. Therefore,
investing in a portfolio of equities and commodities can lead to a more diversified portfolio than
investing in equities alone.
Please note however that past performance is not a guide to future performance and may not be
repeated. The value of investments and the income from them may go down as well as up and you
may not get back the amount originally invested.
What are these
diversifiers?
When we refer to asset classes that diversify the risks associated with the equity market
we could include:
Commodities
Energy, metals and agriculture
Emerging Market Debt
Bonds issued by the governments of developing countries
(e.g. Asia, Latin America)
Emerging Market Equity
Company shares listed on the stock markets of developing countries
Global High Yield Bonds
Bonds issued by companies and other organisations that have a lower
credit rating
Hedge Funds
Funds which can use a variety of strategies in order to achieve an
absolute positive return in any given market cycle
Property
UK and global property (offices, industrial and retail)
Private Equity
Shares in companies that are not listed on a recognised exchange
Each of these asset classes have their own individual risks associated with them and so can be risky
in isolation, as with equities. However it is the practice of spreading risk exposures across a variety of
asset classes, or diversified growth investing, that can lead to a reduction in overall risk or volatility.
The key point
A sensible long-term investment strategy is to invest in a range of different asset classes and not over react
if one particular market falls. By placing money in a number of different asset classes the good returns you
receive from one investment in a certain time period can help offset the poor performance of another.
Important information: This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended
as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice,
or investment recommendations. Information herein is believed to be reliable but Schroder Pension Management Limited does not warrant its completeness or accuracy. Past
performance is not a guide to future performance and may not be repeated. FTSE International Limited (“FTSE”) © FTSE. “FTSE®” is a trade mark of London Stock Exchange
Plc and The Financial Times Limited and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors.
Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data. No further distribution of FTSE Data is
permitted without FTSE’s express written consent. This does not exclude or restrict any duty or liability that Schroder Pension Management Limited (SPML) has to its customers
under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. For further explanation of any financial terms, visit www.
schroders.co.uk/glossary. Issued by Schroder Pension Management Limited, 31 Gresham Street, London EC2V 7QA. Registration no. 5606609 England. Authorised by the
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