How the Past 12 Months Have Reiterated the Importance of a Diversified Portfolio

One of the core principles of investing, portfolio diversification is crucial in order to weather times of substantial market turbulence. The past several years – and the last 12 months in particular – have worked to reiterate this.

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At present, investors are facing the impacts of unprecedented world events on many assets. The emergence of the Coronavirus pandemic in 2020 caused a number of complications for the investment landscape, from the Bank of England (BoE) cutting their base rate to an all-time low, through to extreme volatility within the equity markets.

And as the UK’s economy began to tentatively recover after the end of Coronavirus-related restrictions, the war in Ukraine and soaring inflation – which brought rise to a cost of living crisis – further unsettled many assets.  

Whilst inflation dipped slightly to 9.9% in August, down from 10.1% in July, it remains uncomfortably close to four decade highs, well above the BoEs 2% target, and forecasts suggest it could still reach 13% by Q4. 

At the same time, the interest rates on savings accounts and Cash ISAs continue to hover around lows of circa 2%, clearly failing to come close to keeping pace with inflation and therefore unlikely to be the most appropriate option for investors looking for an asset with growth potential.

This is where investors with a suitable appetite for risk may have traditionally turned to equities, however current market conditions – particularly interest rate hikes in both the UK and US as central banks endeavour to contend with rising inflation – mean we’re witnessing frequent and often severe fluctuations within global markets.

These fluctuations were exemplified in the market’s response to Chancellor Kwasi Kwarteng’s mini-Budget on Friday 23rd September, when the FTSE 100 fell 2% to a three month closing low. 

On Monday 26th September, the S&P 500 posted a new closing low at a level not seen since December 2020, whilst the Dow Jones finished the same day in bear market territory.

However, both cash and equities still have important roles to play in a diversified portfolio. For those who would like an element of security within their portfolio, cash (up to £85,000) is protected by the Financial Services Compensation Scheme (FSCS) and whilst you won’t see your capital grow in a savings account at present, they can allow easy-access to funds that are at no risk of loss. 

Moreover, though the equities markets are prone to short and sometimes medium-term instability, they have the potential to offer attractive long-term returns for investors willing and able to take on the associated risks and give their investments time to ride out fluctuations and falls in value. 

As an example, over the past 35 years, the average annual return for the FTSE 100 was 7.8% (assuming dividends are reinvested) – though it’s important to remember that past performance should not be used as an indicator of future performance.

But many experts agree that, now more than ever, a portfolio made up of just cash and equities or the revered 60:40 portfolio allocation is simply not diversified enough. Investors should look to consider further diversifying their portfolios where possible, adding assets that can be used for volatility dampening and that have the potential to generate attractive returns, but can also boost a portfolio in other key ways.


Diversifying with alternative investments and property

In their 2022 Global Alternatives Outlook report, JP Morgan highlighted the need to adapt to and embrace a “hybrid model for investing in a changing market environment”, stating that amidst current conditions, “investors will find it increasingly difficult to generate stable returns through the public markets alone”. 

And research from Cerulli Associates found that an increasing number of  financial advisors now look to diversify their clients’ portfolios with alternatives, with 70% stating “reducing exposure to public markets” as the primary reason behind alternative asset allocation and 66% stating “volatility dampening” and “downside risk protection”. 

Connection Capital found that high-net-worth investors are already including much higher weightings of alternative assets in their portfolios when compared to five years ago – a crucial consideration for experienced investors with the appropriate appetite for risk.

Their lack of correlation with mainstream assets can make alternative investments particularly beneficial in helping to diversify a portfolio, and their growth over the years has rendered many of them much more easily accessible for investors. 

Amidst the wavering economic backdrop, one alternative asset that has proven somewhat resilient is residential property. The UK’s housing market was one of few assets that actually witnessed some benefits as a result of Covid-19, with a Coronavirus-induced housing boom leading 2021 to be the busiest year for the market in over a decade. 

And though activity is beginning to return to a more standard pace after a remarkably busy few years, demand remains above pre-pandemic levels and after the Chancellor’s permanent cuts to Stamp Duty announcement, it’s thought demand could even pick-up once again. 

Whether through property bonds or direct equity property investments, there are a number of methods of investing into property. Some – such as property bonds via an Innovative Finance ISA (IFISA) – can also offer tax incentives, which are arguably more important than ever at present for making your capital go further.


Building a diversified investment portfolio

It’s clear that some assets are performing better than others at present. But as is always the case when investing, the key to weathering the current market storm looks to be a diversified, well-balanced portfolio with a range of asset classes that can pick-up the slack when others are wavering.