Achieving diversification as the investment landscape evolves

Consensus appears to believe markets are in ‘melt up’ mode as artificially low interest rates and lack of yield elsewhere help to assuage any concerns about the economic recovery and rising inflation. It is particularly at such times that investors should ensure portfolios are adequately diversified relative to risk profiles in order to protect against setbacks. Yet, while acknowledging individual circumstances, there is little consensus as to how this should be best achieved – particularly as a new market regime unfolds. The good news is that sound asset allocation can still produce good risk-adjusted returns.

The theory

Diversification is an important investment discipline which is sometimes overlooked until it is too late. When starting an investment journey, it makes sense to focus on equities – they have performed better than most other assets over the long-term. However, as time passes, investors should increasingly be looking to protect past gains, particularly if financial goals are approaching, for market corrections can be cruel in their timing and devastating in their effect.

The discipline involves reducing portfolio risk by reducing exposure to equities in favour of other ‘uncorrelated’ assets – assets that tend not to move in the same direction as equities over the same period. While few investments will entirely escape a major equity market correction, adequate diversification will help to reduce losses. These other assets can also help to achieve a high and growing income, which investors typically seek as their journey progresses – income being an increasingly important contributor to total return over time.

There are no fixed rules as to the pace and extent of diversification. An investor’s income requirement, investment risk profile and financial objectives are key factors. Perhaps the most important factor is the extent to which a portfolio accounts for overall wealth – a portfolio representing just 5% can afford to take on more risk than one representing 95%, but again individual circumstances are paramount.

The practice

Investors should remember that the very concept will, to varying degrees, see the various assets perform differently even though globalisation has contributed to a rise in correlation between certain asset classes. Investors should therefore retain an element of perspective regarding the market’s individual view of the various components, for the next crisis is unlikely to be a repeat of the last.

However, such ‘conventional’ diversification in isolation may be less effective going forward. Various factors suggest additional nuances are required. Markets have acclimatised in recent years to low economic growth and subdued inflation – as such, conventional bonds and equity ‘growth’ investing have dominated investment strategies. As highlighted in previous pieces, a better balance is now required as governments attempt to engineer strong economic growth and the risk rises of a meaningful increase in inflation. Portfolios need to recognise this transition or they will struggle to outperform.

But something more is still needed. We need again to question the ability of governments and financial institutions to assess risk. Covid-19 was not a ‘black swan’. A major Government assessment only a few years ago, and many esteemed epidemiologists over recent years, identified a pandemic as a most likely danger. And yet the large financial institutions have not factored this at all into their assessments of market risk – once again, reminding us of the folly of forecasting.

Greater portfolio resilience will be required especially as the transition to the new market paradigm unfolds. Unconventional protections will need to be better embraced including derivatives that hedge against market setbacks, such as VIX calls which benefit from volatility and equity put options which benefit from market falls. This is one reason why our more defensive portfolios have increased their exposure to capital preservation investment trusts.

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