Financial advisors and asset managers tout diversification as one of the best ways to mitigate risk while investing.
Typically, the strategy of a diversified portfolio helps investors to experience highs and protect from the lows of certain market segments. But what happens when the whole market crashes?
Kelly Castle, Institutional Business Development at Prescient Investment Management, says that as long as a portfolio is optimally structured, even the fallout of a global crash in markets can be mitigated.
This was something many South Africans would have seen happening in their portfolios in recent months, following the deep economic fallout of the Covid-19 pandemic, which hit markets across the world.
“As long as you have done what you can to ensure your portfolio is optimally structured, you can take comfort in the fact that there is no need to panic,” Castle said.
Even in the time of a market crash, diversification still works as a winning strategy.
“Some asset classes perform when others don’t, therefore, limiting the risk taken,” Castle said. “The expectation is that during a market crash, your equities will be harder hit than your bonds and cash, which has been proven true through many financial crises.”
Pointing to market data around the time of South Africa’s hard lockdown, Castle noted that if you invested all your money into South African property, you would have lost a lot more than if you kept it in cash during this time.
However, she stressed that putting everything into cash also isn’t the optimal strategy.
“If you kept (your investment) in cash for the last five to 10 years, you would not have benefitted from the rallies that other asset classes experienced,” she said.
The solution then, is to hold the old adage true: don’t put all your eggs in once basket.
Balancing the risk by dividing your investment between different asset classes to meet your investment objectives will enable you to avoid concentrating all your investments and running the risk of losing it all, she said.
To feel out a market crash such as the one brought about by the Covid-19 pandemic, Castle said success will depend on how long you are willing to invest the money, and how much risk you are willing to take.
“In (determining these factors), we can determine how much we invest in riskier assets such as equities (shares) versus more conservative assets, such as bonds and cash,” Castle said.
“This is because research shows that you will achieve greater returns by investing in higher risk shares. However, the risk-reward payoff only really materialises over a longer time horizon (typically more than five years).”
Another route is investing in different risk-return profiles of these asset classes.
One way to do this is by investing in multi-asset funds or investing in single asset class funds within a broader investment portfolio, she said.