Why a financial adviser uses a professional fund manager and believes in diversification

The unfolding banking crisis will be resolved in time. In its aftermath, the pertinent questions will revolve around how many investors will permanently lose their capital, investing in what they perceived to be low risk.

Of course, economic, and financial resets like the one we are currently navigating will occur from time-to-time. As the tide changes, we will see who isn’t wearing any clothes.

In other words, the changing conditions quickly reveal who has been flying blind on the back of sheer luck, as compared to those who have applied a modicum of rigour and experience to their investing strategies.

As you read the AFR article written by Christopher Joye, examining the intricacies of the banking??and regulatory sector, it doesn’t take long to realise the level of research required to understand what is risky vs not-so-risky. He outlines the complexity and inter-connectedness between markets and how they function.

What this teaches us, is that the cause/effect relationships are far-reaching and that finding the weak link at a given point is immensely difficult.

In particular, Chris describes?some of the following:

-??????The extraordinary velocity of digitised transactions, leaving Banks susceptible to crises of confidence. Silicon Valley Bank demonstrated that billions in deposits could disappear in a single day, contrary to the slower, manual nature of previous banking collapses.

-??????Short-sellers targeting the weaker banks, in an issue layered with complexity. Hedge funds then attack the banks’ bonds and equities, which are both easy to short. The planting of spurious news stories by short-sellers about latent risks in the banks’ portfolios can help seal the death spiral. This all happens incredibly rapidly.

-??????The slow and reactive response by the Swiss government to Credit Suisse’s crisis was contrary to the style of guarantor measures previously taken by the US Government. This creates immense unpredictability for markets.

How can any average investor expect to properly assess these weak points across multiple asset classes??A non-professional neither has the time, nor the ability to analyse the multiple scenarios that may eventuate.

This is not to say that a professional fund manager will not make mistakes here either, given the unprecedented nature of some of these events. However, investment mandates require diversification within many investment funds, providing a layer of strong protection to the investor.

Would you rather lose 5% of your 10% allocation, or invest 5% of your capital and lose all 5% after assuming that the defensive investment is risk-less?

It’s a common approach for investors to look at any investment and quickly come up with simple reasoning to assume their safety.

“It’s too big to fail.”

“The government will step in.”

“It’s backed by quality property.”

“Too many smart investors are invested…” etc.

This over-simplified analysis can lead to permanent loss of capital.?It’s easy to do and it happens to ordinary investors all the time!

What the average level of analysis fails to appreciate, is the myriad of ways we could lose capital - generally in ways well beyond the knowledge level of most. While these risks have low probability, they become exaggerated in times of crisis.?

How frustrating it must be to chase a mere extra 1% or 2% return, but instead end up losing all your capital? Wouldn’t you rather invest in a fast-growing company, at least entering the investment with the expectation that it could be boom or bust?

It is also important to recognise here that cash and bonds, while generally less risky than equities, deliver lower long-term returns. Investing in sound businesses with growing earnings, while volatile at times, can be easier to understand and provide a better outcome over the long-term.

In conclusion, if you are making greater concentration bets and risk in the defensive portion of your portfolios it might be wise to assess it as an equity-like investment. This way you know what’s really at risk and more importantly, you can choose to be comfortable with your exposure or adjust your expectations.

Ultimately, the complexity that comes with investment decisions such as these is arduous for any investor who is not full-time dedicated to the markets. This explains why savvy investors entrust their portfolio construction and management to professional fund managers.