In search of balance

David Prosser delves into the importance of having a balanced portfolio and what this means for investors.

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It’s the holy grail of investment: all financial advisers talk about the importance of building a balanced portfolio of savings and investments. But what does ‘balanced’ actually mean in practice, and how do you know whether your portfolio is up to scratch?

The first point to make is that there is no one-size-fits-all approach to portfolio planning. The asset allocation appropriate for you will depend on why you’re investing, what you hope to achieve and when – plus how comfortable you feel with taking risk.

For cautious investors or those focused on short-term goals, the right portfolio will be more exposed to cash, fixed-income and other less volatile assets. For more adventurous investors and those able to take a more long-term view – five years or more, say – the stock market will be a happier hunting ground.

Either way, however, you need diversification – rather than putting all your eggs in one basket, your portfolio needs to hold a spread of assets. The idea is that if one of your holdings endures a difficult period, the performance generated by the other assets will compensate.

Mixing it up

This diversification is important in both the short and the long term. In the short term, it can be disturbing to see your investments fall in value or underperform – the US stock market, for example, fell more than 20% in the first half of the year – so it is reassuring to have other assets generating compensatory returns. Longer-term, meanwhile, diversification protects you from failed investments – there is no guarantee any single holding will ever come good, so it’s important to have other assets that will help you towards your investment targets.

This balancing process can smooth out investment performance. In 2019, for example, UK shares gained around 19% while gilts gained 7% – a good year to be in the stock market compared to a safer investment. In 2020, by contrast, shares fell 9% while gilts rose 8%. Investors with 100% exposure to the stock market would have endured a rollercoaster ride over those two years. By contrast, those with portfolios split between equities and gilts would have had a far less hair-raising experience.

When professional investors talk about risk, this is what they mean – the word is effectively synonomous with volatility. The riskiness of a portfolio is its propensity to produce swings in value.

Diversification in practice

It is possible to be very scientific about diversification. Academics have spent a great deal of time analysing the relationships between different asset classes in order to understand how they tend to move together – or not. Asset classes that have high “correlation” with each other tend to rise and fall in sync. Those with low correlations do the opposite.

How, then, to find that balance for yourself? Well, with investment companies, there are two approaches you can take.

The first is to take advantage of the broad range of asset classes to which the investment companies industry offers exposure. In addition to equity funds, investment companies are available that give you access to infrastructure, property, private equity, hedge funds, commodities, and a whole bunch of other specialist investments. Many of these asset classes have very low correlations with the stock market, so this is a good way to build a balanced portfolio on a DIY basis.

Option number two is to get an investment company manager to do the job of diversification on your behalf. The Association of Investment Companies’ Flexible Investment sector contains more than 20 funds where the managers are able to invest across a wide range of asset classes, rather than sticking with just one type of investment. Several of these (but beware – not all) aim to build balanced portfolios with the aim of sheltering investors from some of the downside risk inherent in a more focused fund. They are effectively one-stop-shops for diversification.

For all that, however, it is important to be pragmatic. In truth, it is not possible to eliminate risk altogether – at least not without reducing the return of your portfolio to a pittance. Volatility may feel uncomfortable, but being over-cautious is a mistake: aim for a portfolio that provides a balance of risk and potential return.