Joe Wiggins, Senior Investment Manager, Multi-Manager Strategies Team, Aberdeen Standard Investments
Volatility is one of the only certainties in markets - diversification a time-tested cushion to its effects. But with some commentators discussing increasing correlation between asset classes, how diversified is diversified enough?
Are there myths and misunderstanding about diversification?
Economist and Nobel Prize winner Harry Markowitz called diversification: "the only free lunch in finance". There are certainly undeniable benefits from a risk and return perspective of combining a collection of different assets, all with different characteristics, within a portfolio.
But while it's a simple idea, it can be challenging. By definition, effective diversification means that some of the holdings in portfolios won't be doing as well as others - sometimes for prolonged periods. Rather than accepting this as an inevitable feature of diversification, we often worry too much about the positions that may be underperforming relative to others. And it's tempting to instead invest more in the most successful positions - becoming less diversified, and potentially more risky, in the process.
How has quantitative easing (QE) affected traditional diversification approaches?
Although there's a great deal of speculation about the impact of an era of unconventional monetary policy on asset class performance, it's difficult to draw any clear conclusions. Certainly for much of the past decade we've witnessed high-quality government bonds proving to be an effective diversifier against equity market risk; however, we shouldn't assume that such a relationship is permanent.
Different environments often lead to changes in the correlation between asset classes; being appropriately diversified means taking the potential for such shifts into account when building a portfolio.
How is investment innovation helping greater diversification?
There's now a broader choice available to investors to help them diversify. These range from subsets of core asset classes - such as short-dated bonds, which have a different return profile to conventional bonds - to more sophisticated absolute return funds, which aim to deliver results with less reliance on traditional asset classes.
However, while innovation has certainly broadened the range of investment options available to clients, at its core diversification is a simple and time-tested concept. It's important to remember that as much as diversification is about creating an ‘optimal' portfolio and enhancing risk-adjusted returns, it's also about investor behaviour. Holding a sensibly diversified portfolio should help smooth the investment journey, and encourage investors to stay invested and enjoy the potential long-term benefit of compounding returns.
How diversified is diversified enough?
Being overly diversified can lead to a situation where portfolio risk is too low relative to the investor's objectives. It can also result in a portfolio becoming bloated with assets that add little value from a return or risk perspective.
We ask two key questions when considering the credentials of an asset class from a diversification perspective:
- Is it diversifying? Does it perform in a way that's different to other assets we already hold?
- Is it distinctive? Does it give exposure to securities or strategies that don't currently feature in the portfolio?
Are there risks to diversifying?
The central purpose of diversification is to include different, distinctive risks in a portfolio. Effective diversification means that you shouldn't necessarily be looking to introduce new risks, but ones which lead to improved risk-adjusted outcomes when considered in the context of the broad portfolio.
For example, investing in a direct commercial property fund is often considered one of the best ways of providing portfolio diversification as it offers exposure to tangible assets and a real rental income stream. It does, however, introduce a level of liquidity risk, as commercial property isn't as easy to trade as individual company shares.
We also ask ourselves whether each asset class is expected to contribute to portfolio returns over the long term - to avoid diversification for diversification's sake. For instance, assets such as gold or commodities are often considered good diversifiers, but without a natural income stream the evidence is questionable whether they can add to long-term returns. Similarly, at times, some asset classes might have strong historical evidence of diversification and returns, but their future expected long-term returns may be very depressed due to current elevated valuations.
Building a well-diversified portfolio means considering a broad variety of different asset classes but selecting the assets offering the best chances of maximising returns over the long term.
How would you explain the importance of diversification to a client?
This is difficult to do well, and it's easy to slip into impenetrable jargon when discussing the core concepts of diversification. Simple phrases such as ‘not putting all of your eggs in one basket' are probably more meaningful than introducing the concept of correlation.
Examples from history are also good ways of illustrating the concepts of diversification, e.g. "during this period, equity markets fell by X%, but high quality bonds actually made money". We should also try to talk in very clear terms about each asset in the portfolio - and be happy to explain the role it actually plays.
Joe manages the Aberdeen Standard Investments MyFolio SICAV range and a number of other multi-asset portfolios.
You can find reassurance messages for clients, including around diversification and investing for the long term, in Market volatility - supporting client conversations.
The information in this article should not be regarded as financial advice. The value of investments can go down as well as up, and could be worth less than originally invested. Information is based on our understanding in March 2019.
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