Volatility has returned to investment markets in 2018, with many charity investors likely to have generated a negative return over the first quarter, representing the first quarterly fall in value for a while. This will serve to remind charity trustees that investment comes with bumps in the road. Alongside this pick-up in volatility comes a revival in the idea of diversification.
Diversification is generally a drag on performance in periods of strong equity markets, which accounts for its drop in popularity over the past few years. Why spread your investments into other assets when you’re getting a worse return?
It is at times like these, in choppier markets, that we see how diversification can add value. It protects against the worst of the falls, so investors have to make less to get back into profit. In short, it can smooth the journey down the bumpy road. This is what the Nobel Prize-winning economist Harry Markowitz called the "only free lunch in investing". In theory, diversification can reduce risk without sacrificing returns.
So how can charities diversify their investments? There are three options worth considering. First is diversification of assets – not having just equities and bonds, but including other asset types with different return and risk characteristics. Second, diversification within asset classes – over-concentration in a single company can be dangerous, as a few unlucky foundations holding on to poorly performing donor stock would testify. Third, diversification by manager – not all fund managers are created equal, so perhaps there’s an argument to include more than one manager in your portfolio.
Passive investment in index funds is the ultimate diversification: instead of taking a view on the relative merits of each company, you in effect buy them all.
But does diversification always make sense? The legendary investor Warren Buffet said: "Diversification is protection against ignorance. It makes little sense if you know what you are doing." It is his view that in-depth analysis and concentration in portfolios will reap the greatest rewards. And I do have sympathy with this view.
However, with this strategy, not only do you need to have confidence in your ability to choose the right investments, but you will need to tolerate the swings in value that come with a less diversified approach. A separate Buffet quote emphasises this point: "In the short term, the market is a popularity contest; in the long term it is a weighing machine."
So if you are a truly long-term charity investor, perhaps you are able to adopt a more focused investment strategy and wait for the market to find the value. But for many, diversification remains a way to smooth returns, increasing short-term certainty in inherently uncertain markets.
Kate Rogers is head of policy at Cazenove Charities