Diversity is the key to making investments work in the long term

Financial services group Davy took two phrases and ran them through Google's Trend Analysis function to see how frequently each was searched in Ireland, Australia and the US.

The phrases were ‘get rich quick’ and ‘long term investing’. No prizes for guessing which was searched more often.

Not only did we in Ireland show the most desire for instant wealth, what was perhaps more revealing was that long-term investing barely registered here.

Eoin Corcoran, Davy’s head of portfolio construction, attributes that to a mix of the fact that having wealth to invest in the first place is still relatively new and that we have only recently moved from an era of defined benefit pensions where people didn’t have to give investments any thought at all.

This desire to win the lottery is as human as wanting to lose weight overnight rather than through long-term commitment. But investment also takes long-term commitment and the discipline to stay the course, even when the course gets bumpy as markets do.

The key to doing that is to invest in a diverse portfolio. Globally, the simplest way for investment advisors to explain this to clients is by talking about not putting all their eggs in one basket. In Ireland, it takes only two words put clients off putting their eggs in one basket: bank shares.

The collapse of bank stocks in the financial crisis here after 2008 drove the message home hard. While diversification doesn’t eradicate risk entirely, it does help you manage it.

“In terms of risk, we think the simplest definition is that ‘more things can happen than will’ and this informs our approach to managing portfolios,” says Corcoran.

“You shouldn’t seek to minimise all risks as you will potentially sacrifice too much on the return equation. We think it is important to be diversified across time horizons and economic environments.”

That means helping clients put together a portfolio that will perform both when growth is strong and when it’s weak and whether inflation is rising or falling. “We then make allocation decisions to reflect our current view but it will never be all or nothing,” Corcoran says.

The most common question Kevin Quinn, chief investment strategist at Bank of Ireland, gets asked is: how do I solve this problem?

“Right now it’s: ‘Interest rates are at near zero, what do I do?’ There is an expectation of a silver bullet but the answer is there is no one single solution.”

That’s why a financial advisor starts by asking what it is you want to achieve, what kind of outcomes, within what kind of timeframe.

“From there we work through the trade-offs involved, such as how well could they cope with volatility? Have they an appetite for ups and downs? And what kind of loss could they tolerate or afford to absorb?” Quinn says.

The answers to these questions determine how clients’ savings are invested.

Portfolio diversification theory holds that by spreading your investments, your exposure to any one class of asset is limited. The aim is to smooth volatility and balance risk and reward over time.

Equities are currently up on average 80 per cent compared with March 2020 and up 20 per cent this year, while cash has been effectively negative. Hedge funds, which have had a pretty meagre decade by their own standards, have done a little better over the past year, returning about 6 per cent or 7 per cent compared with bonds which have also been negative.

“Each one of these asset classes will have periods when the sun shines and difficult periods. The theory is that by combining them, you get a slightly more manageable outcome,” says Quinn.

That has been the case despite major economic challenges such as the recession of 2008 and now Covid.

One of the easiest ways to ensure diversity is baked into your investment strategy is to invest in a multi-asset fund.

“In the past we traditionally saw diversity as being about a mix of four asset classes: equities, cash, bonds and property,” says Mark Ryan, principal at Mercer Private Wealth. “We’ve decided over time that within these, there are variations. So, for example, in equities you can have low volatility, high volatility stocks, small cap or large cap companies, and different geographies.”

“So by diversifying even further within asset classes, you get further diversification and less correlation between them, with different asset classes working in different ways at different parts of the economic cycle. For example, in a recession some perform better than others. Those that do well in a bull run will do poorly in a bear run.”

Such funds protect investors from themselves too. “In the past, people might have thought to go 100 per cent into equities, and when equities went badly, they jumped ito cash. So they’d sell at a low and buy at a high. The idea of a multi-asset fund (MAF) is that you get equity-type returns without equity type risks, but mainly it’s the behavioural aspect it guards against. It stops you doing more damage than you should,” Ryan says.

Mercer’s MAFs use a variety of specialised investment managers so you get expertise. They are also designed to adjust on a continuous basis so that the diversity and risk appetite you chose at the outset remains with you all the way through the investment period in a way that didn’t happen prior to the financial crash.

There are all sorts of risks which diversification can mitigate against, including liquidity risk – not being able to sell an amount of your portfolio when you need to – and concentration risk, those bank shares again.

"Unfortunately a huge amount of investors learned that lesson the hard way during the financial crisis," says Daniel Moroney, investment strategist Brewin Dolphin Ireland.

“Diversity is the first step and the easiest way to manage risk and to completely reduce the possibility of your savings going up into thin air because permanent loss of capital is the big risk. Our industry too often encourages people to conflate volatility and risk but lots of investors have much longer time horizons. So long as you are in diversified, high-quality assets, short-term volatility is not something to be afraid of.”