Cape Argus E-dition

THE DIVERSIFICATION PREMIUM

WHY, if you’re a long-term investor, is it better to diversify among higher-risk assets than simply put all your eggs in a low-risk, stable investment?

Last year in March, when Covid-19 was starting to spread around the world, but before the markets plummeted at the end of that month, Dr Adrian Saville, then chief executive of Cannon Asset Managers, wrote an article, “An investment cure for coronavirus: the diversification premium.” It was a warning to long-term investors not to sell off their higher-risk investments in favour of less risky ones, but to ensure that they were well diversified to weather the approaching storm.

“Selling everything ‘risky’ in times of stress to crowd into a ‘safe asset’, such as cash or bonds, may not be as rational as it seems at first blush – especially if you have a long investment timeline,” Saville wrote.

He compared returns on a single, stable investment with those of a multi-asset portfolio, both averaging a return of 5% a year over 25 years and showed that the multi-asset portfolio could generate a substantially higher balance after 25 years.

If you invested R500 000, at a compounded 5% growth rate, the safe, single-asset investment would be worth nearly R1.7 million at the end of 25 years.

In Saville’s example, the multi-asset portfolio is diversified equally across gold, cash, bonds, real estate and equities. Although the average return is 5%, two asset classes (real estate and equities) deliver above-average returns of 7.5% and 10% over the 25 years, while two others (gold and cash) deliver below-average returns of 0% and 2.5%. Bonds deliver 5%.

This diversified portfolio would have finished the 25 years with a final value of R2.3 million – 36% higher than the “stable 5%” portfolio.

In explaining the outcome, Saville says that, with enough time, the compound growth of the higher-returning investments (real estate and equities) in the diversified portfolio more than make up for the lower-returning investments of cash and gold.

“As time lets the power of compounding assert itself, the diversified portfolio therefore begins to accelerate away from the ’smooth’ single-asset portfolio – a difference Jeffrey Levine from Forbes calls the diversification premium,” Saville says.

PERSONAL FINANCE

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2021-06-19T07:00:00.0000000Z

2021-06-19T07:00:00.0000000Z

http://capeargus.pressreader.com/article/282243783550132

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