How a diversified portfolio can help sustain and grow wealth
Investing in multiple assets will improve returns and limit losses during economic upheaval
Unlike any event in recent memory, the Covid-19 pandemic served as a stark reminder that when it comes to financial planning, diversity is key.
A balanced and diversified portfolio of assets is imperative to maintaining and increasing wealth, and those with a diverse portfolio were better able to weather the storm at a time when there was significant volatility and turbulence in the markets.
The pandemic has created challenges as well as new opportunities for investors seeking to diversify their portfolios.
Even as some sectors – airlines and hospitality, for example – went through a difficult cycle, others such as technology, e-commerce and cloud-based computing companies performed well.
Some of the best-performing investments have been in healthcare. This sector is likely to continue to be prominent in 2021, although for different reasons.
While healthcare has largely not been a focus from a growth investment point of view for a long time, an increased focus on innovation along with the pandemic saw biotech become an emerging market that is expected to broaden going forward.
There is also a huge focus on environment, social and governance-focused investments, as more investors realise how these values support their portfolios and provide them with significant opportunities in growing areas such as clean energy, energy efficiency and new technologies.
Various rating agencies, such as Moody’s and Standard and Poor’s, are increasingly using ESG disclosures in their credit ratings – showing that the ESG metric is not a fad anymore. On the contrary, it is becoming an important component of the cost of capital and ultimately having a material impact on businesses.
The importance of asset allocation
One way to adapt to these changing trends is through asset allocation; an investment strategy that helps to create a diversified portfolio by spreading investments across multiple asset classes.
This is vital as every asset class has a specific risk-return profile with varying correlations, ensuring that each reacts differently to similar market conditions. Put simply, by choosing diversified assets wisely, one can benefit from market conditions while remaining sheltered from adverse movements.
In periods of major economic upheaval – such as the pandemic – diverse portfolios help limit losses. However, it is important to remember that while one particular investment may do well at a certain time, no one particular investment will outperform others over the long-term.
With this in mind, a diverse portfolio can help an investor smooth out peaks and troughs and remain consistent.
A diverse portfolio can help an investor smooth out peaks and troughs and remain consistent
It can also be a key factor towards making a transition from a high-net-worth individual to an ultra-high-net-worth individual. Although HNIs already have a steady inflow of wealth to reinvest into family businesses, the stock market or real estate, a planned and balanced asset allocation strategy can go a long way towards securing significant gains in wealth.
Broadly speaking, there are four main benefits to asset allocation.
Achieving the desired return: There is a marked difference in the return potential of each asset class, especially when considered over the longer term. While some asset classes can offer above average returns over the long term, others offer more security and lesser returns.
To move towards and achieve your financial goals, while maintaining the portfolio value, it is imperative that you diversify your assets in ratios best suited for your requirements and risk profile.
Limiting risk to portfolio: The main aim of savings and investments is to protect and grow your wealth. This makes risk mitigation as important as investment growth. Now, if you invest only in low-risk assets, you face the risk of not generating the returns required to achieve your financial goals.
On the other hand, if you invest primarily in high-risk assets, you face the risk of losses and even capital erosion. Asset allocation, however, can help to achieve a tenuous balance between protection and growth by ensuring that a mix of assets can improve the risk-adjusted returns of your portfolio.
Lowering concerns over timing the market: Not even the most seasoned investors can consistently time the markets such that they enter at the bottom and exit at the high. Asset allocation entails investing in multiple asset classes in a certain proportion, based on your risk-return requirements. Thus, entry and exits are systematically decided based on the weights assigned to each asset class.
For example, assume that your portfolio is allocated 60 per cent to equities and 40 per cent to debt. In a rising market, the value of your equity investments increases, thereby increasing their weight in your portfolio.
Adhering to your asset allocation strategy means booking some profits in your equity investments and reducing their weight back to 60 per cent in your portfolio. Thus, the exit decision is systematically made. This is also applicable to the entry decisions.
Overcoming personal biases: Humans are imperfect beings and we could often be wrong in our judgement of the market. A strategic asset allocation ensures that wealth is optimally divided between asset classes, limiting interference from personal or behavioural bias.
Such a diversification ensures that the portfolio is safeguarded from potentially hazardous misjudgments.
Mufazzal Kajiji is the head of Mashreq Gold and executive vice president of Mashreq Bank
Published: April 5, 2021 08:30 AM