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The secret to successful diversification in your investment portfolio

A popular way to manage risk on the financial markets is through diversification. Investing in a broad range of investments, assets classes and geographies might seem simple enough, but getting the right mix to help you reach your goals can be difficult.

In a diversified portfolio, any fall in one asset class should be offset by better performance in another. Whilst evidence suggests that it’s difficult for active stock pickers to consistently outperform the market over time, a diversified portfolio is typically better insulated against downside risk.

At Moneyfarm, we believe a diversified portfolio is likely to create the best outcomes for our investors and our portfolios typically hold seven-14 exchange traded funds (ETFs), diversified across geographies and asset classes.  

Achieving diversification with ETFs

ETFs are popular with investors wanting cost-efficient diversification. An ETF tracks a market index (like the FTSE 100 or S&P 500), specific commodity, bond, or even a basket of assets. In essence, ETFs own shares and trade them to reflect moves in the index they are tracking.

They can be traded exactly like individual stocks, but because they are based on an underlying index or investment, they offer more diversification than individual shares. As they don’t involve active management, ETFs charge lower costs than traditional investment funds.

Just because ETFs track markets rather than seeking to outperform them, it’s important to note that this doesn’t mean an investment portfolio based on ETFs involves no active decision-making. Far from it. The enormous choice of ETFs gives investment managers many opportunities to refine and tune portfolios.

In our view, investors get more choice at a lower cost than traditional active fund management when their wealth manager puts a lot of thought into choosing the best ETFs. Although Moneyfarm uses passive instruments, we don’t take a passive approach to investing.

Read more about how our Asset Allocation team pick the right ETFs for your portfolio.

It’s up to our team of experts to decide the asset allocation of each portfolio – proportion of each asset class in our portfolios – and pick which ETFs to invest in to reflect these constraints.

Asset allocation

Moneyfarm’s investment process is based around strategic and tactical asset allocation –  portfolio rebalancing. Strategic asset allocation looks over a long-term investment horizon, whilst our tactical activities make adjustments over the short-to-medium term.

Each year, we update our long-term view on the market to make sure our portfolios are in the best position to deliver growth.

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By making an investment, your capital is at risk.

Having chosen our investment strategy and mix of assets, we apply a portfolio optimisation tool to choose the best distribution of assets within a portfolio. We aim to build portfolios that target the highest level of expected returns for a given level of risk.

The Optimisation process

When it comes to computing the proportion of each asset class in the different portfolios, Modern Portfolio Theory is a key starting point.

The Markowitz theory believes that risk-averse investors can build portfolios that offer the maximum possible expected return for a given level of risk.  As optimal asset allocations obtained with traditional approach are sensitive to even the smallest of changes in inputs, our asset allocation team run a robust optimisation process.

To accurately analyse the expected return and volatility for this calculation, our team of investment experts do the following:

Build an efficient frontier

We use optimisation algorithms for each scenario and build an efficient frontier – maximum expected return in a worst case scenario for each targeted level of risk, represented by Conditional VaR. The final frontier is an average of all of different scenarios.

Incorporate uncertainty in calculations

Whilst we don’t directly aim to minimise volatility, we know that the path to our long-term goal won’t be smooth. To incorporate the uncertainty of short-term fluctuations on the financial markets into our forecasts, we use stochastic optimisation algorithms in this optimisation process.

Scope out Value at Risk

We scope out the worst-case scenario with Value at Risk (VaR) using the Monte Carlo simulation. VaR estimates how much your portfolio could lose in value over a period of time.

Find the right asset allocation

We then find the allocation that maximises the return and minimises the risk in the worst scenario of realised returns. In the case of low expected returns, we also include constraints on the weights of the asset classes for each level estimated.

Why it’s important to get diversification right

These different steps, whilst simplified here, are the backbone of our asset allocation process, which helps our investment committee tailor portfolios to individual investor profiles.

By ensuring your investments reflect your financial background, appetite for risk and financial habit, your portfolio can get you one step closer to your financial goals – whatever they may be.

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