Secrets Of Success: Risks, returns and more adventure

There are many things wrong with the basic financial theory that is taught in most universities and business schools, but one thing it has unquestionably helped to do is to focus investors' minds on the importance of building sensible, well-constructed portfolios - that is to say, to encourage us to spend a little time thinking carefully about the balance of individual funds or shares that we own.

The information technology revolution has given us lots of reliable data that enables us to look in more detail at the risk and return characteristics of virtually any share, bond or fund in all the leading markets of the world, should we so wish. There is always the danger that such a wealth of data will bestow a spurious impression of comfortable precision.

Knowing, for example, that the Russian stock market went up by, say, 84.78 per cent in year X tends to reinforce the idea that the Russian market is somehow as secure a place to invest as our own, which is clearly not the case. Nevertheless, the fact is that the range of opportunities that is now practically open to UK investors is materially greater than it was 20, or even 10, years ago.

You do not have to go as far as subscribing to modern portfolio theory (a flawed conception) to realise that there are some obvious benefits to be gained from mixing investments with differing risk and return characteristics.

The mathematical mechanics of mean variance optimisation, the application of which to investment helped to win Harry Markowitz a belated Nobel Prize in economics, may well be beyond the average investor's competence.

But you only need common sense to realise that combining assets that behave in divergent ways in different market conditions is likely to reduce your risk of loss over periods of time.

Seventy years ago, you could diversify by buying a range of UK shares and bonds and, if you were brave enough, diversify further by putting money into an investment trust that invested directly overseas. (In the days of Empire, many British companies derived a significant chunk of their earnings from overseas markets, in any event.)

Today, the choice is infinitely wider. The table, which summarises the risk and return characteristics of the average equity fund investing in different overseas markets, illustrates the point. You could add scores of other data points to this example, adding such things as government bonds, stock market sectors (investible through exchange-traded funds), commodities, hedge funds and property.

The options can also be illustrated by looking at the correlation between the performance of different markets. Taking the 12 fund averages in the table, for example, you will find that they have very different correlations with the FTSE All-Share index.

Four of the 12 have correlation coefficients of less than 0.5, implying that combining them with a UK equity portfolio would produce a smoother result, less vulnerable to the normal cyclical patterns of financial markets.

It is true that you can overdo this kind of diversification. Historical patterns in correlations do not hold in all circumstances: in 2002, in the latter stages of the bear market, for example, nearly all the classes in the table (except for gold and precious metals) fell to some extent. There was no real hiding place, other than cash, in that (thankfully exceptional) year.

You also need to beware of adding new asset classes just for the sake of it: you might well decide, for example, that global emerging markets exposure is sufficient, without adding specific Russian or Latin American exposure as well (personally, I would still avoid the Russian market like the plague, despite its spectacular volatility and growing maturity).

Nevertheless, as the table shows, broadening the mix of your investments does have advantages, combining as it does the prospect of higher returns and relatively low correlations (most of the time). As always, the best long-term value propositions are usually to be found in those corners of the risk-return quadrant that are out of line with most of the rest.

This is one reason why an increased exposure to Japan and the gold/precious metals markets is likely to prove rewarding over the next five to 10 years. As it happens, there are also good investment reasons in both cases for feeling confident that they should perform well. Japan seems to be coming out of its long deflationary decline at last, and the supply and demand equations in industrial commodities also look favourable.

The appointment of Ben Bernanke as the new Chairman of the Federal Reserve, the US central bank, has rightly attracted acres of newsprint comment this week. There is no more vital job as far as investors are concerned, and in a global economy the appointment is a matter of concern for investors in every financial market, the UK included.

Having said that, the most important thing that can be said about Alan Greenspan's newly appointed successor is what the appointment is not - namely, an exercise in cronyism or political dogmatism. Financial markets like nothing worse than such important jobs being handed to those without the necessary qualifications or, worse still, with a pre-ordained agenda. That has been tried before, with disastrous consequences.

While Bernanke is an academic with some strong convictions, he is no pie-in-the-sky Ivy League theoretician, but a man who has earned the respect of his peers on both the academic and the market sides of finance.

Whether he goofs over the next few years remains to be seen, but the first reaction to his appointment has to be one of genuine relief. It has removed one palpable risk from the market outlook, for which we should all be grateful.

jd@intelligent-investor.co.uk