The Power of Diversification

Recent months have not been an easy time for investors, with escalating trade tensions, political uncertainty and softening global growth contributing to a volatile market. Morgan Stanley Research expects volatility to remain elevated over the coming months.

Volatility is not to be feared if you are a long term investor but it’s important to take sensible steps to manage it. The most effective tool at your disposal is diversification. 

Diversification is built on the observation that different assets perform differently even under the same conditions. Carefully blending assets with different characteristics can create a portfolio better able to withstand changing market and economic conditions.

Diversification is best achieved through asset allocation – how your investments are divided among various asset classes such as equities, fixed income and cash.  Academic research suggests that the eventual investment outcome for a portfolio is significantly determined by the asset allocation chosen.

Furthermore, by investing across a carefully chosen range of asset classes, you can lower the risk of your portfolio than if you had held just one asset class, like Australian shares. Remember, managing risk is just as important as maximising returns. 

A long-term strategic asset allocation (SAA) framework coupled with short-term tactical asset allocation (TAA) views that incorporates ongoing market developments are important to reaching your financial goals.    

Strategic asset allocation should be seen as the long term benchmark for portfolio returns and volatility. SAA helps investors reach their goals over the long-term at a targeted level of risk.

The second point to make regarding a SAA portfolio is that it achieves superior risk-adjusted returns than investing via a single asset class – this is due to the benefits of diversification.

It should be the framework upon which other investment decisions are made.

Tactical asset allocation (TAA) looks at short-term opportunities within or between asset classes in an attempt to add additional value to the portfolio.

Careful study of market conditions can often yield situations where tilts away from the SAA can enhance returns. 

It’s important to remember there’s no such thing as the ‘best’ asset allocation – it all depends on what makes you comfortable and gives you the best chance at meeting your financial goals.

Altering your asset class mix through the asset allocation decision will change a portfolio’s risk/return profile. Simplistically, the more risk you take, the higher returns you can expect over the long term.

When you are selecting your risk profile, these are some of the things you should consider:    

• Return objective: What are your long term wealth plans?

• Capital preservation vs. wealth generation: Is your priority capital preservation (conservative investor profile) or wealth generation (growth-oriented investor profile)?

• Willingness and capacity to take on risk: What is your willingness (how well can you withstand years of negative returns) and capacity (what is your financial position) to take on risk?

• Need to take on risk: Based on your current financial position, how much risk do you need to take on i.e. balance taking on unnecessary risk vs. avoiding falling short of wealth?

• Investment horizon: How long do you expect to hold your investment portfolio? 

Given the complexity of asset allocation and the importance of getting it right, we recommend seeking professional advice.

Morgan Stanley’s research team focuses on aggregating data from across the globe and monitoring these on a daily basis to constantly fine-tune their asset allocation advice and make appropriate recommendations. Your Morgan Stanley financial adviser has access to these insights and appropriate product solutions, which may help you position your portfolio. 

For more on asset allocation, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.