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Why asset class diversification is crucial when investing

Investors who currently have all their money tied up in equities are having a bad time of it. The China crisis on Monday 24th August sent shockwaves around the world causing share prices to nosedive. Immediately after Black Monday the FTSE 100 was down 4.6% with £73.75bn wiped off the value of shares and a similar story played out across the globe everywhere from France and Germany to New York and Tokyo. Markets are still struggling to recover.

Those with diversified portfolios – holding assets across different classes including bonds, property and commodities – will have weathered the storm far better than those whose portfolios contain only shares. This table comparing the performance of different asset classes over a ten year period explains why.

Let’s take the example of equities in emerging markets, shown in light blue. In the mid-noughties those with shares in these markets would have been feeling pretty smug, with returns coming out at or near the top in the league table for three years running. In 2005 alone they grew by a whopping 50.46%.

Fast forward to 2008 however, and, bang, emerging market equities plummeted to the bottom of the table showing losses of 35.18%. That’s some fall from grace. Investors prone to knee-jerk reactions might have been tempted to offload these stocks at this point but that would have been a big mistake because just one year later share prices yo-yoed right back up to the top with gains of 59.39%.

Volatility such as this is extreme but if you trace the trajectories of all the different coloured asset classes on the grid, you’ll see that they all move up and down the table to varying degrees. This demonstrates just how difficult (or even impossible) it is to predict exactly how an asset class is going to perform at any given time.

As that is undeniably the case, the best way to protect against potential downside is to diversify. If you spread your investments across different asset classes the massive peaks and troughs of some will be offset by the more gentle ups and downs of others.

Investment and risk are consistent bedfellows and nothing can completely remove the risk of investing, however diversification can go a long way towards protecting against downside volatility. Diversification of assets is key but you can also diversify further by investing in different geographical regions and different sectors.

If that is all starting to sound a bit complicated, why not talk to me about how to take an investment short cut with a multi-asset portfolio or MAP. The reallocation of assets is taken care of for you by professional investment managers, backed by detailed data from a whole team of dedicated analysts. That means that you get all the benefits of diversified investment without the hard work.

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