At Work: Finance and IT - Investment - Diversification beats the 'single bet'

Mark Humphreys, senior investment consultant at Watson Wyatt

Does it make sense to put all your eggs in one basket? Common sense says no, but institutional investors have historically relied almost entirely on equities to generate most of their returns, meaning that equities have also been their main contributor to risk.

This reliance is changing, however, as investors realise the benefits of a wider range of asset classes and discover that too little diversification in portfolios means more volatility in asset values and large potential losses.

Significant obstacles to diversification have to be overcome, including constraints of governance, entrenched fund manager relationships, misperceptions and fear of change.

According to our research, which covers £15.5bn of charitable assets, about 60 per cent of charity trustees who sit on investment committees believe equities will be the highest- performing asset class in the future, which explains why UK charities have a high average exposure to equities of about 65 per cent of their portfolios. Most believe that between 25 and 50 per cent equity is their optimal allocation. This is probably an indication of charities' willingness to reduce their exposure over time by diversifying away from a single bet on the stock market.

The research also shows that nearly 80 per cent of UK charity trustees with financial qualifications see diversification as essential to sound investment.

Although it is true that the highest return is likely to come from a single bet on an asset that goes up the most, holding a broader portfolio produces a lower but more stable return and acts as protection against a single bet going wrong. Asset diversity is less about seeking the highest return and more about protection from poor performance.

Alternative assets have characteristics that make them potentially attractive for charities and foundations. Property, currency and even infrastructure have expected returns comparable to those from equities but do not behave in a similar way. Chosen carefully and matched with the right investment manager, alternative asset classes can be rewarding, particularly in this volatile and low-return environment. Some of these assets classes come with a high price tag, however.

Even the best investment strategies will tend to produce poor results if they are poorly executed, so they are not always suitable for trustee bodies with governance constraints. It is worth noting that such constraints can be overcome through appropriate delegation or the use of diversification funds that specifically incorporate a wide range of assets.

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