DIVERSIFICATION AND THE

RISK/RETURN TRADE-OFF

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2 Property
Equities

Bonds

Advising you as a financial adviser.

Cash

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WHAT IS RISK? DON’T FORGET ABOUT INFLATION

The word “risk” can sound alarming, but risk is something we deal with every day. If you’re trying to achieve greater wealth over the long term, it’s important to consider
Crossing the road or going on holiday, for example, involve different types of risk. the impact of inflation. Rising prices have an alarming way of eroding the value
of investments that don’t grow fast enough.
We regularly take these risks because of the commensurate rewards an activity involves.

For this reason, your returns need to do better than inflation - ideally, a lot better. A cash
With an investment, the risk we have to consider is the possibility of a fall
account paying interest of 5% a year may sound appealing, but if inflation is 3% a year,
in the value of our money. Different types of investment carry different levels of risk, your real return is just 2% - and that’s before you’ve paid tax on your earnings! In contrast,
which need to be considered against the potential rewards. A higher level of risk you can see that an investment in equities can generate significant returns after inflation.
normally means that the potential reward is greater, but there is also a bigger
chance of losing money. Note: Unlike a deposit account, the value of these investments and the income from them
can go down as well as up and you may get back less than you invested. Past performance
is not a reliable indicator of future results.
The diagram below illustrates the risk/return spectrum. The investments towards
the left carry less risk, but the potential returns are lower. Those at the other end carry Real return on €50,000 over 10 years
more risk, but also have more chance of producing greater returns. 80,000
70,000
60,000
The risk/return spectrum
50,000
€
40,000
LOWER RISK, LOWER POTENTIAL RETURNS HIGHER RISK, HIGHER POTENTIAL RETURNS
30,000
20,000
10,000
Cash funds Bond funds Equity funds Individual equities 0
Cash Equities

Initial investment Growth

LINKING RISK TO YOUR GOALS Source: Fidelity/Datastream using MSCI and JP Morgan data 31.07.1997 - 31.07.2007.
Both cash and equity returns assume full reinvestment of income, and do not include any charges.

We all have different goals in life. Some of these could be just a few years away, such as
saving for a holiday or a new car, while with others the money might not be needed for a
decade or two - such as retirement planning, or saving for a child’s education.
For short-term goals, it’s often a good idea to put your savings into low risk investments
such as cash deposits, given the higher level of security offered.
However, cash deposits are not such a good option to meet your long-term goals.
Over the years, the potentially smaller returns generated by cash investments could
mean you end up with rather less than you expected.
KEY FACT
Keeping your money in a cash account over the long-term is unlikely to be the most
effective wealth-creation strategy. This is because inflation eats away at any returns
from cash investments over the longer term. When time is on your side, it can be
a good idea to invest in equity funds - as historically shares have proved to be the
strongest asset class.

Equities (shares) are riskier than cash and bonds over short periods, however, it is
important to remember that they have traditionally offered the strongest increase in
investment value over time.
CAN RISK BE REDUCED?
YES – THROUGH DIVERSIFICATION

Because various investment markets tend to experience good and bad periods at 2) Diversity of geographical region
different times, one of the most effective ways to achieve returns with an acceptable level
The world’s major markets are all very different. They are influenced by their own
of risk is to spread your money between several different types of assets and markets.
business cycles, economic trends and political, social and cultural factors. They may also
Known as diversification, this strategy increases the chance that you will benefit from
be affected by common issues, such as oil prices, environmental factors and global
growth in any market that is currently doing well, and reduces the effect any falling
conflict, but won’t necessarily react in the same way. The difference between returns can
market can have on the value of your investments.
be significant and unpredictable, as shown below.
Diversification can be achieved in a number of ways, including:
• investment category • geographical region • industry sector Performance rotates among many markets

• investment style • company size

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Best
50% 58% 56% 107% 7% -6% -19% 36% 33% 45% 34%
38% 57% 42% 51% 5% -7% -21% 32% 23% 35% 28%
1) Diversity of investment category 38% 47% 39% 47% 2% -12% -23% 28% 20% 31% 22%
29% 45% 31% 41% 2% -12% -23% 23% 18% 29% 22%
In the graph below the yellow line shows different combinations of equity and bond
23% 45% 30% 30% -2% -16% -25% 21% 13% 27% 20%
portfolios and their respective risk/return profiles. The blue line demonstrates how
23% 38% 23% 25% -5% -18% -28% 20% 11% 27% 20%
adding another asset class (in this case - property fund) to the equity and bond portfolio,
22% 36% 22% 23% -8% -18% -28% 20% 11% 26% 19%
can increase overall portfolio returns for the same level of risk. This principle can be
21% 33% 20% 22% -10% -18% -29% 19% 10% 26% 18%
further applied when including specialist asset classes in a portfolio, such as emerging 19% 32% 17% 17% -10% -19% -33% 17% 10% 20% 18%
market equities or high-yield bonds. 16% 30% 16% 16% -11% -19% -33% 15% 8% 20% 15%

Efficient frontiers 8% 28% 14% 8% -13% -23% -38% 13% 6% 17% 15%
16% -5% -14% -9% 0% -20% -24% -43% 7% 4% 5% 7%
Worst

14%
Belgium Germany Netherlands Switzerland

100% Europe Europe Italy Nordic UK

12%
Equity
+10% Global Property France Japan Spain USA
Annualised return

10%
Source: S&P. Net income returns in local currency as at 31.12.06.

8%

This disparity is not only a recent phenomenon. Indeed, it is characteristic of the

6%
international economy that some markets do well at the same time that others are going
4%
through difficult times. Rather than trying to predict which markets will be the next
100% EMU Inv. to boom, a valuable strategy might be to spread your investments across a number
Grade Bonds
2%
of the world’s major markets. This will result in some exposure to changes in exchange
0%
rates, but it will ensure that your investments are not fully exposed to the fortunes
0% 2% 4% 6% 8% 10% 12% 14% 16%
of only one market.
Annualised risk
Source: Datastream - local currency, total return 31/07/2002 - 31/07/2007. Bonds = ML EMU Large Cap Inv Grade,
Europe Equities = MSCI Europe, Property = FTSE EPRA/NAREIT Global. Total returns do not include the effect of charges.

When investing in foreign markets returns may go up or down as a result of

currency fluctuations.
3) Diversity of industry sector Growth vs Value
120

Relative performance: equilibrium=100

Having a portfolio that invests entirely in your home market may also mean you miss out
on the world’s most important sectors. You can see from the chart below that individual 110
markets tend to favour certain sectors and have less exposure to others. No single
country offers full diversification across the entire range of sectors, so if you limit yourself 100
to one country, you are likely to overlook opportunities offered by industries which are
under-represented in that market.
90

Different markets favour different sectors

60.00 80

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50.00
MSCI World Growth Index MSCI World Value Index

Fidelity datastream. Price index return in USD from 31.7.97 to 31.7.07.

40.00

5) Diversity of company size

% 30.00
A further dimension of diversification can be built into your portfolio by combining funds
that focus on companies of varying sizes, because while some economic climates favour
20.00
small companies, others are more suited to their larger rivals.

10.00

KEY FACT
0.00 Structuring your portfolio to achieve diversification across investment categories,
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enjoy more consistent returns throughout all stages of the business cycle.
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France Italy Germany Spain Europe

Fidelity datastream using MSCI data as at 31.7.07, in Euros

4) Diversity of investment style

The principle behind international diversification can also be applied to the varying styles
of investing. In the same way that different countries can be at different points in their
economic cycle, so different investment styles such as ‘value’ and ‘growth’ prove more
successful in different economic environments.
“Value” investing involves looking for companies that are undervalued by the market,
perhaps because their potential is not fully appreciated or they are in currently
unfashionable sectors. “Growth” companies, on the other hand, may be young and
innovative, with the potential to expand their business.
HOW TO DIVERSIFY? EASY
Collectively managed funds offered by professional investment groups like Fidelity
provide a cheap, easy and effective method of diversification. Because your money
is pooled together with that of other investors, each fund is large enough to diversify
across dozens, hundreds and even thousands of individual assets. What’s more, all the
investment decisions are managed by experts working full-time to maximize your returns.

If you are in a position to combine different types of funds in your portfolio, you might Fidelity only gives information about its own products and services and does not provide
want to create a balance between those that concentrate on growth opportunities and investment advice based on individual circumstances. If you are unsure which investment
others focusing on value stocks. is right for you, you should contact a Financial Adviser.