3 minute read
Unit trusts - how diversification helps to reduce risk
BY SHRIYA ROY Quantitative Analyst, Prescient Investment Management
The saying ‘don’t put all your eggs in one basket’ is one of the best ways to make sense of diversification, and why it’s so important when deciding where to put your money. In a nutshell: diversification in unit trusts, if done correctly, can reduce market risk. There are two ways to diversify – between asset classes and within asset classes.
What is diversification and why do you need it?
Diversification involves allocating funds across various unrelated asset classes, or across various unrelated assets within asset classes, to reduce the chance of losing money when one group of assets reacts unfavourably to a certain change in market conditions.
But why reduce risk when ‘higher risk means higher returns?’ Diversification will not eliminate risk entirely, but the objective is to reduce market risk so that investors are not taking on risk unnecessarily. After all, more risk also means a higher chance of losing your money when the odds are against you.
Diversifying between asset classes means choosing to invest in asset classes that have unrelated performance values. A common unrelated pair is bonds and equities. This is because bond yields have an inverse relationship with the price of equities. To elaborate – when bond prices rise, yields drop, which makes them less appealing. Investors then find equities more attractive since the dividend yield they receive would most probably be higher than the bond yield. This will cause equity prices to rise, since investors want to earn the highest yield possible. By investing in both asset classes instead of one, you are limiting your downside risk.
Diversifying within asset classes means choosing to invest in individual, unrelated assets within an asset class. For example, putting all your money into SA equities may not be the safest bet. Instead, it’s a better idea to diversify by allocating between SA equities and US equities. Having exposure to both assets instead of one will reduce risk in situations where, for example, the SARB increases interest rates (all else being equal). In this case, investors will most probably flee from SA equities because they’ll benefit more from the higher interest rate by saving, causing SA equity prices to drop. In this event, exposure to US equities will limit the losses.
Multi-asset funds are a popular choice for unit trust strategies due to the diversification benefits of asset allocation. Prescient Investment Management’s Multi- Asset Funds offer a mix of onshore and offshore assets and allocate between and within asset classes. On top of diversifying over common assets such as equities and bonds, the funds also allocate toward preference shares, inflation-linked bonds and renewable energy.
To achieve long-term sustainable returns, putting your money in a unit trust needs to be for the long term. Therefore, choosing the right unit trust with the right mix of assets that appeal to you is of utmost importance. In the words of Bastian Teichgreeber, Prescient Investment Management CIO, “Never be too sure of one big story and rather diversify risks; the worst habit in finance is to become overconfident.”
Disclaimer: Prescient Investment Management (Pty) Ltd is an authorised financial services provider (FSP 612). The value of investments may go up as well as down and past performance is not necessarily a guide to future performance. There are risks involved in buying or selling a financial product. This document is for information purposes only and does not constitute or form part of any offer to issue or sell or any solicitation of any offer to subscribe for or purchase any particular investments. Opinions expressed in this document may be changed without notice at any time after publication. We therefore disclaim any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable directly or indirectly to the use of or reliance upon the information. Supervised representative.
