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Investment diversity today is all about the global economy

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Thursday July 7, 2011 at 9:00am

Gone are the days when an investment in the FTSE all share index would provide a reliably, healthy rate of return. For the last 11 years the FTSE all share index has returned only 2.4% per annum.

The investment winners today are those who focus on keeping costs low whilst also investing in a broader, globally diversified portfolio. One such globally diversified portfolio when back tested returned 7.4% per annum for each of the past 11 years. Compare this with the FTSE 100 which has actually lost money over the same time period.

How was such a return achieved you may ask. Well the answer is by keeping costs as low as possible and by holding equities in the same weighting as global stock market weightings. There is a lot of science behind such a portfolio but the point is that the market owes investors a return (around 8% historically) for the risk they take by investing in company shares rather than AAA rated Gilts. The problem is that most investors do not capture that return.

Most people talk about the FTSE 100 as if it was the stock market but the above clearly shows that it bears no resemblance to the global stock market in terms of performance. By holding your investments in the same weighting as world markets you are getting the best diversification possible.

Markets represent the sum total of all investors estimates of individual company values at any point in time. Hence all known events are reflected in the price of the market. So the only things that can move markets are the unexpected events. This is why stock market returns are volatile over the short term but surprisingly consistent over the long term.

To put the unexpected into context I looked at where the market uncertainty is coming from right now. Generally accepted wisdom is that over the past decade the UK economy has been skewed towards consumer expenditure with the consequential increase in consumer debt to over 100% of UK GDP at one stage, higher than US consumer debt. The warning signs were there but we only see them with the benefit of hindsight.

Accepted practice a few years ago, such as 125% mortgages, buy to let property deposits funded by credit cards, banks like HBOS competing in the property market with high risk loans at very low interest rates etc, appear reckless in the current environment. But very few saw the banking crisis coming until it had actually arrived. Hence it was an unexpected event as evidenced by the 2008 stock market correction.

We now find ourselves in what most are calling a financial and banking crisis with the accepted wisdom that recovery from such a situation takes much longer than recovery from the more normal economic recession. However, UK manufacturing in the 1970’s was around 22% of the economy, it fell to 9% but is now back up to 12% so a 33% improvement on the low. Manufacturing has fallen in Europe too, (Germany was 35% now down to 21%). The latest UK figures showed 450,000 jobs created in the past year (despite 140,000 public sector job losses). Who would have thought it, so much despondency but the figures, again unexpectedly tell a happier story.

Another story from the US tells of some 41 million US citizens collecting food stamps and over 50% of families accepting some form of federal or state support, who knows where the US is headed next, chances are whatever happens it will be unexpected. Then you have booming Australia, well their currency is booming anyway, which has made their exports expensive to the rest of the world, thus damaging the country’s wine industry. 25% of the country’s exports go to China and a further 27% go to countries like Japan and South Korea who are in turn dependent upon China. Unlike investors, countries find it difficult to diversify but if China sneezes South East Asia will probably catch a cold. If it happens this will move stock markets which means the market couldn’t anticipate it.

The rule is to have as much diversification as possible in your investments because what moves markets is the unexpected. And the more diversification you hold the less you are at risk from the effects of the unexpected.

Andy Parker
Chartered Accountant and Chartered Financial Planner

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