2 November 2011

How to Choose Your Investments

The classic way to select investments for a portfolio draws on "Modern Portfolio Theory" which results from research in the 1960's and 70's. It recognises the trade-off between risk and return (where "risk" generally means volatility), and also the benefits of diversification.

Diversification is a big factor which is often not considered in an "amateur" portfolio. For example, if you add a higher risk investment to a portfolio, it could actually reduce the overall risk!

But there are several problems with the approach:
  • It is based on historic data, typically over the previous three-year period, and that is often insufficient to give a balanced view
  • It takes no account of the future, and we all have some view on what is likely to happen
  • It demonstrably doesn't work during times of crisis, when the benefits of diversification disappear because all asset classes end up perfoming in a synchronised way (e.g. going down together - like they did on 2008!)
So a theoretical approach may have improved the overall quality of investment portfolios. Nevertheless, investing remains an art rather than a science, and perhaps the best thing that financial advisers can do for their clients is to help them understand that.

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