The Single Best Means for Reducing Risk
Principle #4: Asset class diversification is the
single best means for reducing risk.
Asset classes are groups of investments that possess similar characteristics, perform similarly within the market and are subject to the same laws and regulations. Asset classes include both broad categories (such as bonds, commodities or emerging market stocks) and specific stock classifications (such as small-cap value, momentum or international large).
In short, asset classes are segments of the market. How they are weighted (allocated) within a portfolio will contribute significantly to the overall success of its investment holdings.
Remember the oft-repeated advice, “don’t put all of your eggs in one basket?” The same adage rings true for asset class allocation strategies. Diversification distributes risk across numerous portfolio investment categories (asset classes) in order to offset our collective inability to select the market’s top performing investments with any degree of consistency or level of scientific accuracy or measure. Asset class diversification decreases the volatility, or risk, within a portfolio while at the same time provides a reliable means for consistent incremental growth over time.
The table below compares two investor portfolios — each achieves an average annual return of 10%. Why are the 10-year and 30-year returns so drastically different between the risky and the stable portfolios?
When 10% Is Not 10%
The stable portfolio investor has applied extreme asset class diversification within the portfolio to generate consistent incremental growth — and thus, is rewarded with far greater net return over time than the risky investor, who holds a more ‘exciting,’ albeit volatile (risky) portfolio.
We fully subscribe to the scientifically validated principle of asset class diversification. We systematically invest in tens of thousands of companies spanning the globe and inclusive of virtually all asset classes (currently 17). This strategy — academically proven to perform consistently over time — optimizes the risk-return relationship and balance within our client portfolios. Most significantly, a thoughtful asset class diversification strategy significantly increases the likelihood of extending a portfolio’s longevity.
Source: Mercer Advisors Investment Committee, 2011.