Michael Caetano, a founder and Senior Investment Director at TMGA Wealth Management, discusses the importance of diversification.

In TMGA's last article with Business Life, ‘Negotiating a VUCA world’, we discussed the importance of having a patient, disciplined approach to investing. Here, we’ll look in more detail at this approach, specifically in relation to diversification and the role it plays in ensuring that investment portfolios are robust enough for the long term, able to withstand the impact of an evolving economic environment, and in a good position to achieve our clients’ objectives over an appropriate time horizon.

Why Diversify?
Diversification is important as not all investments carry the same degree of risk or return and are often highly correlated. As market volatility increases or decreases, investments can react differently to each other and portfolio performance may vary to a wide degree, translating to gains or losses for investors, depending on risk tolerance, type of investment and time horizon.

So from a risk perspective, it’s important to factor appropriate diversification into the construction and management of investment portfolios – bearing in mind that diversification is not one-dimensional; it has many sides and layers.

Facets of Diversification
Our starting point in constructing investment portfolios is to seek suitable levels of exposure across the three main asset classes: equities, fixed income and alternatives.

Having the correct blend of diversification at this level is important as it helps mitigate the potential for underlying investments to all move in the same direction. It is equally important to avoid asset classes, sectors and themes that are highly correlated. This can help generate a more consistent and positive return profile over the long term.

In terms of asset class, equities – which typically produce higher returns – can be subject to wide price movements, especially when the macro environment changes and uncertainty is prevalent. Fixed income is normally deemed as being more conservative and less volatile, so exposure can act as a good portfolio hedge.

Alternatives can also be used as portfolio diversifiers, to generate returns that are less correlated to the other two asset classes.

Further diversification within asset classes can be achieved by investing in collective investment schemes, where the investor benefits from inherent diversification of the underlying fund investments, gaining exposure to specific themes, sectors and regions.

Style also has an important part to play in portfolio diversification. ‘Growth’ sectors are typically defined as long duration assets meaning that revenue and profitability profiles of growth companies typically increase at a faster rate than the market average over a business cycle.

‘Value’ sectors can be seen as investing in businesses at a discount to their intrinsic or book value. These companies tend to have a lower valuation compared to the market or index. The nature of these investments can also be deemed more cyclical and economically sensitive, and they tend to perform better when the cost of capital rises.

After a decade of superior returns from growth investing, the recent shift in the economic, monetary and geopolitical landscape has catalysed the renaissance of value investing.

The current market sell-off can result in investors being torn between growth and value in terms of which is most conducive to outperform in the current environment.

Our view is that the right balance between the two styles is more favourable for longer term sustainable returns than reacting to short-term market trends.

TMGA’s Approach
We diversify through the allocation of different types of investments within and across asset classes, regions, sectors and secular themes. We analyse investment opportunities in order to identify attributes and characteristics that are complementary to one another, thereby minimising concentration risk, style drift and factor bias.

We have the flexibility to alter exposure, when necessary, without deviating from our core investment philosophy of patience and discipline.

We believe that diversification is one of the most important investment principles. The aim is to achieve the right level, seeking to minimise risk and dampen volatility. We are not distracted by market noise or tempted by short term trends. Instead, our focus is on delivering positive risk-adjusted returns to meet our clients’ long-term financial objectives.