What is diversification? The challenge for investors is that we typically confuse ‘diversification’ with ‘variety’.
Investor Howard Marks described this problem best when he said: “Intelligent diversification means not just investing in a bunch of different things, but in things that respond differently to the same factors”.
While this may appear obvious, it can be challenging to implement, as the difference in behaviour of the diversifying asset can be uncomfortable.
For example, if one builds a portfolio primarily of equities that are typically rising in value, then the diversifying asset may be providing zero or a negative real return in most circumstances.
This creates ‘line item risk’ for the investor who is naturally disappointed with the holding performing less well than others on their statement.
It is nevertheless essential that advisers and portfolio managers overcome this focus on short-term underperformance if they are to provide a portfolio that meets the risk and return aspirations of the client.
When do you need diversified assets?
In addition to the ‘why’ and the ‘how’, one of the questions facing investors when thinking about diversification is the ‘when’.
Although the answer may appear obvious, when equity prices fall, this is too simplistic a response. Attempting to offset a small decline in equity prices may result in too high a proportion of the portfolio being invested in the diversifying asset and therefore cost too much in lost upside potential.
Equally, while it is worth owning diversifying assets at all times, the opportunity costs and value of those assets varies through time. When equity prices are high, the value of the diversifiers are higher and vice versa.
Allocating to diversifying assets poses only a minor challenge when these assets have positive expected real returns, as the proportion of the portfolio held in diversifiers will likely lower long-term returns, but continue to help the client make progress towards their goals.
However, when this is not the case, ie diversifiers have negative expected real returns, diversifying assets represent a cost akin to an insurance premium.
In this situation, investors should select diversifying assets as they would an insurance contract, balancing the lowest cost (negative real returns) with the best quality of cover (probability of offsetting losses elsewhere in the portfolio).
Over-emphasising one of these factors at the expense of the other is likely to lead to disappointing results for investors.
In order to avoid this, it is necessary to have a clear expectation of future returns and the potential risks of the asset class.
As most bonds have well-defined return expectations, and so it is possible to forecast returns to maturity with reasonable confidence, the temptation for investors is to allocate capital that is required for diversification to bonds with a high-risk profile.
