LOOK AT IT THIS WAY
On paper, the football team looked unbeatable. Freed of a salary cap, the coach had opened his chequebook and bought in the best talent available. Everyone was a star. Problem was they had lost their first three games in a row, and badly.
The difference between a team full of stars and a star team is well documented in professional sport. Great coaches are those who are able to create something bigger and better than the simple sum of the individual components.
It’s the overall mix that counts
A great adviser knows an investment portfolio works the same way. What’s important is not so much which individual stocks you hold, but the overall mix of stocks, bonds, property and cash and how this asset allocation is suited to the client’s goal.
Indeed, this broad mix of assets and how diversified they are typically explains the bulk in the variation in returns between one portfolio and another. It is not so much how each component performs in isolation but how they co-vary.
One zigs, another zags
Covariance measures how two assets move in relation to each other. A negative covariance points to the assets moving in opposite directions. In non-technical terms, it means that as there one component ‘’zigs” another “zags”.
This is important for the individual investor because it offers the advantage of diversification (not relying too much on a couple of “star” performers) and cuts back on the overall volatility of the portfolio.
You don’t want a team full of strikers
In football terms, you don’t want to have a team full of flamboyant strikers. You also want a couple of dour defenders, who give nothing away. And you want some flexible midfielders who provide the vital link between defence and attack.
What matters is the overall shape of the team and how the individual elements interact. This is why just buying in the supposed best players in each position doesn’t necessarily work. You need a feel for the whole, not just the separate parts.
This is how great coaches, and great financial planners, are made.
The aim of this series to help demystify investing and personal finance by using simple visual metaphors. If you’ve found this latest analogy helpful, you may want to try these:
OUR STRATEGIC PARTNERS
Content such as this would not be possible without the support of our strategic partners, to whom we are very grateful.
We have three partners in the UK:
Bloomsbury Wealth, a London-based financial planning firm;
Sparrows Capital, which manages assets for family offices and institutions and also provides model portfolios to advice firms; and
OpenMoney, which offers access to financial advice and low-cost portfolios to ordinary investors.
We also have a strategic partner in Ireland:
PFP Financial Services, a financial planning firm in Dublin.
We are currently seeking strategic partnerships in North America and Australasia with firms that share our evidence-based and client-focused philosophy. If you’re interested in finding out more, do get in touch.
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