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Odds on diversification

3 mins
David McFadzean, 
January 2020
Odds on diversification

Unlike tossing a coin, portfolio management is not a game of chance and the risks are not usually 50/50.  There is a huge range of potential investments to choose from and a professional wealth manager should be able to demonstrate consistent results over a long period with a greater success rate than 50%.

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Let’s start by tossing a coin. Assume you have £100,000 in savings. The bet is: heads, I give you another £100,000 and you’ve doubled your money; tails, you give me your £100,000 and you’re left with nothing. The coin is fair and each outcome has a 50% chance – would you take the bet?

If you say no, you would definitely be in the majority. Most of us feel the pain of losses much more than we savour the joy of gains, so even a completely fair 50/50 bet seems too much of a risk. Especially with money we have worked hard to earn and has taken a long time to accumulate.

So how can I make the bet more palatable? What if I toss 100 coins (all at once) and you are betting £1,000 of your £100,000 savings on each coin. In theory it’s still possible that every coin comes up tails and you lose all of your savings, but of course the most likely outcome is that 50 of the coins land heads, the other 50 land tails and you are left where you started with £100,000.

You also now have a 46% chance of being up on the bet (51 or more heads) and more than an 18% chance of being at least £10,000 ahead (55 or more heads.)

More importantly, the chances of 60 or more of the coins landing as tails (you lose) is less than 3%, which means you would have to be very unlucky to lose £20,000 or more.

(Finally, for the statistically minded, your chances of losing everything have gone from 50% to something in the order of 7.889 x 10-31, a vanishingly small number.)

It all starts to sound much more reasonable. In any venture involving uncertain results, diversifying across a range of ‘investments’ drastically reduces the probability of extreme outcomes and makes participation a much more comfortable experience. Put simply – diversification reduces risk, even when there is only one game in town.

In the real world of portfolio management, where the risks are not usually 50/50 and there is a huge range of potential investments, there are even more opportunities to diversify and even more benefits from doing so. A good portfolio manager will take advantage of the following:

  1. Spreading your investments across a range of different asset classes. This will normally include cash, bonds, equities, property and alternative investments.  Each of these asset classes will behave differently according to different market conditions – it is very unlikely they will all perform poorly at the same time.
  2. Spreading your investments across a range of countries – by investing globally, and not just in your home country, your portfolio will be exposed to different stages of the economic cycle. This will also help dampen the effect of any economic or political issue affecting a particular country or region.
  3. Spreading your investment across a range of industry sectors. Similar to countries, different sectors of the economy react differently to economic events.  For example, a rise in interest rates may be good for banks, but bad for industrial companies who need to borrow to invest in equipment or other manufacturing capacity.
  4. Spreading your investments across a range of different fund managers. Some fund managers are experts in global equities, others are experts in UK bonds or emerging market debt.  Not only will your portfolio benefit from experts in their particular field, but each of these fund managers will have different economic and valuation models which will have greater or lesser success at different times.

 

Finally, don’t forget that, unlike tossing a coin, portfolio management is not a game of chance. Yes, investments can go down as well as up, but a professional wealth manager should be able to demonstrate they can deliver consistent results over a long period with a greater success rate than 50%. Does yours?

At Nedbank Private Wealth, we have been working closely with private clients across generations, and are ideally placed to create wealth solutions tailored to your needs, both within the UK and internationally. If you would like to find out more about how we can help you diversify your investments, please contact us on +44 (0)1624 645000.

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David McFadzean

David McFadzean

Head of Investments

David is responsible for developing and delivering Nedbank Private Wealth’s investment proposition for private individuals, trustees and investment consultants. He works in partnership with our teams of private bankers in fulfilling our purpose of protecting our clients, advising them with integrity and making their lives easier. With over 25 years’ experience working for global blue-chip companies in both London and Jersey, he provides investment solutions to a wide variety of clients around the world. David is a Chartered Fellow of the Chartered Institute of Securities and Investment and a Chartered Wealth Manager.

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