The value of diversification

Article written by Patrick Cairns

The benefits of a balanced portfolio over the long term.

At the start of 2016, when markets were still reeling from the blow-out in bond yields after the dismissal of Nhlanhla Nene from the finance ministry, few would have been brave enough to predict that South African bonds would be the best-performing asset class for that year. Yet that is exactly what happened.

For the 12 months to December 31 2016, South African bonds returned 15.4%. This was significantly higher than the next best-performing asset class – the 10.2% gain in South African listed property.

What’s more telling is that the year before, South African bonds had been bottom of the pile. The asset class had returned -3.9%.

What this brief example shows is how difficult it is to anticipate how markets are going to perform. Another would be that when the rand was at nearly R17 to the dollar in the wake of Nene’s dismissal, many investors were rushing their money offshore thinking that the currency could only go one way.

In retrospect, however, that would have been entirely the wrong thing to do. International asset classes all underperformed in rand terms during 2016 as the currency strengthened again.

“When you are investing, it’s very difficult to know what’s going to happen in the short term,” says Graham Tucker at MacroSolutions, the manager of the Old Mutual Balanced Fund. “That’s why you have to make decisions based on fundamentals that play out over the long term.”

To illustrate this point, MacroSolutions produced the below table showing how different asset classes have performed over the last five years:

Even over this short period, there is a lot of variance in the relative performance of individual asset classes from one year to the next. No asset class was the top performer for two consecutive years.

If one extends the analysis over the last ten years, the changes in relative performance become even greater. Over that time period, gold, global bonds, South African equity, and South African bonds have all been both the best-performing and the worst-performing asset class in different years.

This makes the performance of the MacroSolutions Balanced Index interesting. This is not an actual fund, but a static combination of asset classes designed to illustrate how a typical balanced fund would have performed.

While individual asset classes are constantly moving up and down the table, the index retains a fairly consistent position in the top half. With the exceptions of 2016 and 2008, it also regularly outperforms inflation.

This illustrates the value of diversification. Spreading your investment across asset classes means that you are exposed to different sources of risk and return while also minimising big swings in performance.

“Over the long term, you need growth assets in your portfolio,” says Tucker. “You need to have exposure to equity and property that give you returns that combat the effects of inflation. But the problem with growth assets is that they come with risk. They will be more volatile.”

Including other asset classes smooths some of this out, allowing investors to access real returns, but at lower risk. To illustrate this further, MacroSolutions showed how the performance of the balanced index over the long term comes in only marginally below that of South African equities:

What this shows is that, over the long term, a diversified portfolio can deliver returns not significantly below those of the best-performing individual asset classes. However, they make it much easier for investors to remain invested because those returns come in a much less volatile, more consistent pattern.