At a recent investment conference we were amazed to hear that the average car spends only 4% of its life in motion. Despite this lack of use most motorists insist that their car has the most up to date safety features in case of an accident, such as airbags.
In many ways an investment portfolio can be viewed in the same way. When creating the ideal portfolio the individual investments, such as funds, should as a collective meet the desired risk and return objective over the investment time horizon, the journey. In order to achieve this you will need to construct a well-diversified portfolio. This will typically include a blend of asset classes such as equities, bonds and property. Within each asset class it is also sensible to create a level of diversification amongst the funds chosen which will perform differently in certain market conditions.
Diversification is the element to your portfolio which we would qualify as the airbag. Since the markets bottomed in March 2009 most asset classes have enjoyed a significant rally. This is something which investors have become accustomed to. We have reached a point however where we are now witnessing divergence amongst economies around the world. Economies are now moving at different paces, along with central bank monetary policy, causing investment markets to oscillate which has seen the return of volatility in both equities and bonds.
Diversification amongst asset classes helps to reduce some of this volatility and can be achieved through careful analysis of correlation. Diversification amongst funds can also help to achieve lower volatility. Through careful analysis of correlation and qualitative analysis, such as understanding the investment process and positioning within each fund, we can look to achieve this, even within funds which are members of the same sector.
In order to achieve this however the investor must be comfortable that the selected funds are likely to perform to different degrees during the various stages of the investment cycle. This differentiation in terms of returns can be difficult to understand for some, particularly when amongst funds within the same sector. Some funds may be more aggressively positioned and therefore perform strongly in rising markets. Underperformance by more defensively positioned funds can prove an agitation under such a scenario, but when markets weaken the downside protection offered by such funds is always most welcome.
This is what makes the airbag important, you never know when it might be needed, but when it is required to reduce the impact of any crash you will be very relieved to find it is already there!