Investing lessons on assets, risk, and diversification

Time is a critical factor when considering risks and rewards in investing.

  • Some investments look great over certain periods of time and terrible over others.
  • The length of time you hold a particular investment can change its risk/reward profile.
  • Small percentage differences add up over the long term.

Does this look like a good investment?

great-crash-of-1987-UK-graph

This graph shows the great stock market crash of October 1987. London’s largest companies lost one-third of their value in just a few days. How would that feel?

Here’s what happened over the next five years:

after-great-stock-market-crash-1987

The big crash is still visible, on the left hand side of the graph, but UK shares had recovered back to pre-crash levels just 18 months later. The stock market then went basically nowhere for the next three years.

In this case, the best time to invest was when it felt worse – right after the crash!

Past performance is no guarantee of the future, but we can’t ignore its lessons.

Today the Great Crash of ’87 barely registers on this three decade graph of the FTSE 100:

ftse-100-long-term-graph

So do markets always come back if you wait long enough?

Investors in Japan in the late 1980s have not been so fortunate:

japan-stock-market-long-term-graph

More than 20 years later, the Japanese index is still roughly two-thirds off its peak. How long is their long term?

Let’s consider a different case. Does this look like a good investment?

UK-gilts-post-2008-to-2012-graph

This graph shows the progress of a UK gilt fund between 2008 and the start of 2012.

Gilts – UK government bonds – are the safest investment after cash for UK citizens. So a fund invested in gilts should do well, right?

Well, here’s how the same gilt fund has done since the start of 2012:

gilts-2012-2013-graph

Investors in this less risky fund have lost money, even after reinvesting all the income from gilts.

And here’s how the gilt fund has done from 2012 compared to UK shares:

gilts-vs-shares-graph-since-2012

Since the start of 2012, the ‘safe’ gilt fund (blue) has fallen in value 3%, while the ‘risky’ FTSE 100 (red) has increased 15%. (Aside: shares have been more volatile.)

I am not making an argument here for shares versus gilts, or vice versa. This is just an example.

Any investment must be considered over different time scales, not just the past month. ‘Safety’ is relative, and depends on valuation. Things can go down and bounce back, or stay down.

Time and diversification

We don’t have a time machine, and we don’t have a crystal ball. We cannot invest in the past with hindsight, and we cannot be sure of tomorrow’s winners.

But we can spread our risk among different kinds of investments (assets).

By holding a collection of assets we can smooth out the ups and downs, and maybe turn that volatility to our advantage!

  • Recipe for poor returns – Chop and change holdings to chase recent strong performers, and ignore history, diversification, and relative valuation
  • Recipe for good returns – Have a plan, stick to it, consider neglected asset classes, remember history and reversion to the mean.

Different kinds of investments – like cash, bonds, property, and shares – are called asset classes. For example, cash is an asset class. Barclays shares are a specific investment within the asset class of shares.

Here is a typical spread of returns from six different asset classes over an illustrative decade-long period:

investing-lesson-six-assets

It doesn’t matter what the different assets are here – this is just an example.

The important thing to look at is the shape of the graphs, and the numbers in the following table.

Asset Total Return Annualised Worst year Best year
A 34% 3.3% 1% 7%
B 48% 4.5% -7% 8%
C 80% 6.7% -16% 19%
D 165% 11.4% -21% 57%
E 36% 3.5% -6% 8%
F -6% -.7% -22% 20%

Note: Numbers for illustration only

Where:

  • Total return is how much you’d made by the start of year 101
  • Annualised is the equivalent annual rate of rate of return
  • Worst year is the most negative down year for that asset class
  • Best year is the best annual return for that asset class

In this series of returns and graphs we can see that:

  • Different assets behave differently at different times
  • The smoothed ‘annualised’ return hides a lot of big yearly swings!
  • Small differences in annual return make a big difference longer term

Why pick one when you can have them all?

If we had that table in year one, then we’d have put all our money in Asset D and made a fortune.

But we won’t and never will. We can’t be sure about the future. As for being guided by the recent past, if anything, the best asset over the prior ten years is more likely to do relatively worse over the next ten (but no guarantees!)

What if we hedged our bets and split our money across all six assets in year one?

Here’s how things would have turned out after a decade.

  Total Return Annualised Worst year Best year
Portfolio 59% 5.3% -3.5% 14.7%

Note: Numbers for illustration only

  • The worse year we’re down 3.5%, versus the worst 22% decline in Asset F
  • The best year we’re up 14.7%, compared to the best 57% rise in Asset D
  • Our return of 59% beats four of the six classes’ individual total returns
  • Volatility2 is lower compared to holding either one of those outperforming assets, which is nice

What if we tried to take advantage of the volatility, by trimming our winners and adding to the poor performers every year?

As a simple illustration, here’s what happens if every year we sold everything and then reinvested our money again, equally split between the six asset classes:

  Total Return Annualised Worst year Best year
Portfolio 61% 5.5% -3.6% 15.4%

Key takeaways

  • Holding a mix of different kinds of assets can smooth your returns
  • The peaks and troughs are lower, and so are the maximum losses
  • The price you pay for diversification is you will never make the best returns from holding only the best asset class
  • But since you can’t know in advance what will do best, is that such a cost?

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you (we publish three times a week) and you’ll never miss a lesson! And why not tell a friend to help them get started?

Note on comments: This series is for beginners, and any comments should reflect that please, rather than confuse or make irrelevant points. I will moderate hard. Thanks!

  1. i.e. After nine full years of investment
  2. Volatility describes how often or how far an asset goes up and down

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