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Surprises and uncertainty prove value of diversification

by William Arnold | Jan 27, 2015

Predicting the future is fraught with danger because of the world’s complexity and randomness. This holds true regardless of how intelligent or well-resourced a person may be.

In 2014, as with every year before, we saw many asset classes achieve returns that were wholly unexpected by forecasters. This highlights a central truth of investing, that in most cases long-term returns are maximised by making your portfolio robust and diverse rather than trying to pick future events.

This was most recently illustrated on the 15th of January, when the Swiss National Bank sent parts of the financial world into chaos with its ­decision to remove the cap on the Swiss currency's exchange rate with the euro. The surprise decision cost investment banks hundreds of millions of dollars and pushed some currency brokers and hedge funds to the wall. At one point, the Swiss franc appreciated more than 40% against the euro.

2015 is not yet a month old and already we have had this major event that wasn't predicted by anyone. Not one of the hundreds of market commentators providing their annual December forecasts saw it coming. Closer to home, another prime example of uncertainty is the RBA’s monthly interest rate decision including its direction, magnitude and timing. Westpac’s Bill Evans is predicting back-to-back cuts in February and March (after previously forecasting that the next move was up). ANZ, NAB, Deutsche, Macquarie, and Goldman Sachs are also predicting a 2% cash rate by year end after likewise turning 180 degrees from claims the easing cycle was over. There are also many analysts who believe the RBA will not budge this year (CBA, Citibank and Merrill Lynch) and others who forecast a rate hike (Barclays, TD Securities, HSBC, JP Morgan and QIC).

With so many failed forecasts why even bother? In defence of the forecasters, it certainly isn't a lack of intelligence or experience. It is ­simply the nature of a complex world. Complexity makes for a system that is unpredictable.

As investors, we are much better off focusing on how we can protect our portfolios from any future event instead of trying to predict which one will come our way.  The key is to recognise that the future is unpredictable, that random events are going to happen, and to build an investment portfolio that is robust enough to withstand the randomness.

Take for example asset class returns for 2014.  The winners and losers were surprising, especially given the commentary at this time last year. At the start of 2014 there was a chorus of economic commentators calling on investors to sell government bonds as they reasoned that the US Fed had to start raising interest rates in 2014. Those rate rises didn’t happen. In fact, economic conditions in some economies deteriorated and global government bond yields contracted and prices of the bonds rose.

This meant that Global Government Bonds (AUD hedged) were the third best performing asset class for 2014, with Australian Composite Bonds (the Composite Bond Index comprises approximately 70% government bonds) coming a close fourth, up 11% and 10% respectively. While not shown in the graph below, unhedged Global Government Bonds would have been the second top performer if currency appreciation was included. Australian shares had a relatively poor year with a 5% increase according to Philo Capital, as shown in the graph below.

Those heavily exposed to oil/energy companies would have been ­hammered with the unexpected precipitous decline in oil and resources prices, while those exiting government bonds given the expectation of interest rate rises missed out on some of the highest returns.

All of this goes to show that we cannot predict the future regardless of how intelligent, experienced, or well-resourced we are.  This is why portfolio diversification - across industry, capital structure, bond type, currency and many other factors - is an indispensable strategy for investors.  

Please refer to Elizabeth Moran’s article Best bonds right now for individual investment ideas.

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