Diversify Your Investments - dummies

By David Stevenson

Many UK investors intrinsically understand the concept of not putting all your eggs in one basket and probably practise a primitive form of diversification. Academic economists have taken this commonsense notion and turned it into the noble idea of modern portfolio theory.

I’m not going to bore you to death with a lengthy exposition of the ins and outs of this very specialised academic field. Suffice to say that most investors have three building blocks that comprise their total return:

  • Risk-free return: Usually the rate of return you get from cash.

  • Return from beta: The return you get above the risk-free rate of return from holding an asset class such as shares or a market. So if the risk-free rate of return is 2 per cent and you buy a tracker for the UK FTSE All Share index that gives you 8 per cent per year, your beta is 6 per cent.

  • Return from alpha: The value added by a financial manager that’s derived by the person moving away from the beta. Most managers aren’t very good at adding this alpha, but they continue to charge you extra in terms of fees regardless!

Be careful with the distinction between beta and alpha, especially as regards fund managers. After a good year in which the market’s overall value has greatly increased, you see many fund managers trumpeting their own individual success.

This blatant mis-marketing frequently confuses the beta of a market (the overall return from investing in a market) with the alpha skills of the fund manager (that is, what special thing the person did that resulted in the higher return).

With alpha, look for consistent outperformance by a fund manager, not just one year’s good result followed by endless average performances.