Also a fair number of wealth managers seem to be recommending higher exposure to ‘alternative investments’ such as private equity funds.
These can never be as transparent as listed equity funds (the values of the underlying assets are not publicly verifiable) and the fees charged are generally a multiple of those charged in mutual funds.
Arguments that such funds are a strong diversifier seem spurious – you may as well say that a rising equity market is highly diversified by placing bets on the horses at Cheltenham. Yes, it is. But that doesn’t amount to prudent investment policy.
The practice
So what diversification is worthwhile? In my view, listed equities and government bonds serve most investment requirements. Government bonds give complete clarity on how much income you receive each year and how much money you get back when the bond matures – the date on the bond.
If you want clarity on your payments over five to 10 years, then bonds (or bank money market funds) are the solution. But no bond is a sure-fire way of paying a bill in, say, 10 years time, as the bill itself is likely to rise with inflation while the bond will not change in value.
By way of contrast: equities tend to cope with inflation over the long term. Also, equity investing allows diversification by stock, industrial sector and by region of operation. Not all equities rise and fall together. This is born out by analysis of historic equity returns, but there are a number of caveats:
Historic equity returns are most compelling as long as investments are held for more than 10 years. In this way, equity investing is a younger person’s game compared to bond investing.
Returns are very dependent on when you invest: whether equities are good value when you buy them - but assessing this requires analysis and buying when things are cheap requires patience and nerve.
For instance, March 2020 was a great time to buy shares – the current public inquiry on Covid identifies the perfect moment as it was also the moment of greatest fear of the pandemic.
It’s easy to look back at these moments of fear and to believe that one would be brave and buy shares next time; but perhaps it is more realistic and less stressful to drip money into markets each month when valuations seem ok.
Diversifying geographically tends to add opportunities while also reducing risk. Equity markets are correlated, but some are more correlated than others. In crises such as the 2008 market fall, holding Japanese equities worked very well to balance Western equity exposure. Also, during times of crisis, oil shares and gold mining shares often rise when markets fall. So a level of geographic diversification seems worthwhile.
