A common query from investors is why investment portfolios contain a mixture of assets, including those that have underperformed relative to others.
While it may seem logical to invest solely in the best-performing assets, this approach overlooks a fundamental principle of investment management: risk and diversification.
At George Square Financial Management, our investment portfolios are constructed to deliver the best return for a client’s chosen risk level. This approach is designed to increase the probability of achieving long-term financial objectives while managing potential losses during periods of market volatility.
The role of risk in investment returns
Long-term data, covering over a century of market performance, indicates that higher-risk assets such as equities generally outperform lower-risk assets like government bonds. However, equities are also prone to significant falls in value. In extreme market conditions, equity investments can fall by 50% or more.
Minimising portfolio losses during market downturns is a key objective for most people, as large losses can materially affect the long-term growth of a portfolio. A strategy that controls downside risk, even at the cost of slightly lower gains in positive market environments, increases the likelihood of ultimately achieving your financial goals.
Portfolio diversification: balancing risk
Consider one of the best-performing stock markets in the world for the last ten years – the US stock market* – compared to a diversified medium-risk portfolio with George Square. We can use modelling tools that look at thousands of different possible outcomes for these investments in the next ten years, known as stochastic modelling, to show the range of possibilities that could lie ahead.
The modelling could show that, in some scenarios, such a portfolio might return more than 200%, but in other scenarios it might fall by as much as 50%. In contrast, the path that a diversified medium-risk portfolio may take is far less extreme. Though it’s significantly less likely that you would achieve returns as high as 200%, your chance of losing more than a small amount of money is low.
When the two scenarios are examined together, the diversified portfolio is a far safer place to be than at the potential extremes of the undiversified portfolio invested only in US shares.
*it’s important to note that past performance is not a reliable predictor of future results, especially given current valuations and geopolitical risk.
The value of strategic portfolio diversification
Portfolio diversification involves deliberately holding assets that may behave differently in various economic scenarios. This helps to mitigate portfolio volatility and supports disciplined, long-term investing. It is not intended to maximise short-term gains but to deliver more consistent returns across varying market conditions.
Investors should expect:
- A spread of asset performance within the portfolio, with some holdings outperforming and others lagging, depending on market conditions.
- Lower relative losses during market downturns, reflecting the portfolio’s defensive components.
- More modest gains during market rallies, due to the reduced concentration in high-risk assets.
This balanced performance profile supports more reliable progress towards long-term objectives, such as retirement planning or capital preservation.
You can read more about the key benefits of having a well-diversified portfolio here.
Intelligent investment advice
At George Square Financial Management, we provide intelligent, creative investment advice to individuals, trusts, families, charities and businesses. We excel at analysing your existing portfolio and assessing how this can best be optimised – often in a more tax efficient or cost-effective manner. We can also guide you through tough financial climates such as during an economic downturn.
For comprehensive investment diversification advice, please call the George Square Financial Management team on 0115 947 5545 or send us a message here.