Five legitimate questions about diversification

A lot has been claimed for diversification: in particular, Nobel Prize winner Harry Markowitz’s badged it ‘the only free lunch in finance’, implying that it was, essentially, money for nothing. It has also been championed as a panacea to the ills of volatility. As such, clients may be baffled as to why it doesn’t seem to improve their long-term portfolio returns very much.

Over the past decade, investors would have been vastly better off in the stock market than diversifying their exposure and, for the most part, diversifying that stock market exposure between, say, value and growth, wouldn’t have done a lot to mitigate volatility. It has been a one horse race – US markets and technology. However, it isn’t time to rewrite the laws of investment just yet.

What changed?

There used to be the view that if you held equities and bonds, across a number of sectors and a number of different countries, you would be sufficiently diversified. Bonds would protect you if stock markets fell; a blend of ‘value’ and ‘growth’ equities would see you through the usual stock market cycles and holding a blend of geographic regions would give you exposure to lots of different sectors and economies.

That theory has gone awry. Loose monetary policy – in the form of low interest rates and quantitative easing – has pushed investors into higher growth areas. It has supported equity and bond markets at the same time, while leaving ‘value’ areas unloved. In an increasingly globalised world, geographic diversification hasn’t worked effectively. Equally, disruptive technologies have seen whole sectors become obsolete. Against this backdrop the normal rules of diversification have had to be redrawn.

How should diversification work today?

The risk models used by asset allocators are becoming more sophisticated. Rather than assuming that an investor can hold, say, bonds and equities and that will be sufficiently diversified, these models can judge risks at a more granular level. As such, it is possible to tell whether a portfolio is over-exposed to a rise in interest rates, or the oil price. This runs across asset class and provides a much more sophisticated view of diversification.

Does this mean it’s not enough to hold bonds and equities?

Probably not. The correlation between bonds and equities has increased significantly, largely thanks to the unusual actions of central banks in recent years. This has meant that instead of bonds protecting investors at times of economic weakness and equities rising at times of economic strength, both have moved higher in response to lower interest rates.

For diversification to be doing its job, the various parts of a portfolio need to move in different directions at different points in the market cycle. With this in mind, investors need to look beyond simple asset class diversification to create resilient portfolios.

What are these unusual-looking investments doing in my portfolio?

If a long-only stock and bond portfolio isn’t full diversification, investors need alternative assets that move in a different direction. Assets such as infrastructure, private equity or specialist property are not necessarily geared to the economic cycle and provide that much-needed diversification. They can also provide a valuable source of income at a time when income sources are scarce.

Should fixed income be in my portfolio at all?

This is a fair question. Fixed income looks unappealing as an investment – yields are at record lows, leaving little scope for capital appreciation. At the same time, it is increasingly difficult to use bonds to generate an inflation-beating income. Government bonds can still act as a diversifying asset when stock markets go bad. During the recent crisis, the UK 10-year gilt saw its yield drop from around 0.8% at the start of the year to around 0.3%. This means its price rose as stock markets fell. Fixed income still has a role, but investors need to be highly selective.

At a time when all asset classes have risen, it has not been the best decade to showcase the importance of diversification. However, improving returns isn’t the main aim of diversification. It is designed to limit volatility, ensuring your portfolio won’t take the full force of any correction in stock markets. Diversification tends to be your friend just when you think you don’t need it any more. That moment may be just around the corner.