Diversification needs a rethink

The more diverse an investment portfolio is the lower the risk associated with it. That’s both the theory and, by and large, the practice.

“Diversity is the closest thing there is to a free lunch in investment” says Daniel Moroney, investment strategist with Brewin Dolphin Ireland.

“The biggest risk for investors, the one that keeps them awake at night, is permanent loss of capital,” says Moroney. That is not to be confused with dips that are the result of normal market fluctuations, but the kind that occurs when, say, you invest only in Irish bank shares, and just before the financial crisis of 2008.

The way to avoid such a catastrophe is through diversification, and the good news is that it has never been easier or more cost effective to achieve it thanks to the huge range of diversified Exchange Traded Funds now available to investors.

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Many track the performance of a global stock market indices. “It means that for a relatively modest sum of money you get exposure to tens of thousands of companies under the bonnet,” says Moroney.

Sticking with your investment over time, including during periods of volatility, takes discipline, however. In the past two years we’ve seen a pandemic, war and the return of inflation, all of which have had an impact on markets.

After a long decline, interest rates are now on the way up. For nearly half a century people have made money from both fixed income bonds and equities, says Kevin Quinn, chief investment strategist at Bank of Ireland. When the pandemic struck central banks flooded the market with liquidity, and both equities and bonds did well. But bonds denominated in euro currencies have been routed this year, fuelled by the European Central Bank’s decision to end quantitative easing. Equities are down too.

On the other hand if you held US investments you’d have been protected somewhat by the strength of the dollar over the euro.

“There is truth in the adage that diversification is the free lunch in investments, but it has been different this time around,” says Quinn.

The traditional diversification debate in the industry has always been between value or growth stocks. Growth stocks, which include technology companies, have been beaten very badly this year, while value stocks in areas such as energy, financials and utilities, have traded at low valuations for many years and not performed well. “That has now flipped,” says Quinn.

Gold has traditionally been viewed as a natural hedge. “We live in a time of unprecedented central bank influence,” says Stephen Flood, director of Bullion Services at GoldCore.

Central bank policies such as quantitative easing, forward guidance and rapid interest rate adjustments have all created an atmosphere “where policy and not macroeconomic drivers hold court over the markets and their anticipated performance. Negative interest rates are an economic abomination, re-taxing the after-tax savings and pensions of citizens,” says Flood.

“In ordinary times diversification is considered the only free lunch in investing, that is to say spreading your investment across many asset classes and durations. The traditional 60:40 equities to bonds allocation is the most famous approach. But what happens if central bank actions can be shown to manipulate the prices of all assets, by artificially adjusting interest rates and buying asset classes outright? We can see now the correlation between central banks’ balance sheets and the broad markets as being almost perfectly correlated. Central banks have actively interfered in most markets and in doing so have created the now famous acronym TINA - There Is No Alternative, forcing investors to take more and more risks for modest gains.”

Diversifying across asset classes is still the best way to reduce investment risk. “In normal market conditions, and particularly over time, the return generated by an investment will be largely dependent on its exposure to growth and defensive assets. Growth assets focus on producing higher investment returns while also being exposed to higher levels of short-term risk, while the role of defensive assets focuses more on capital preservation, with lower expected returns and lower levels of risk attaching,” says Oliver O’Connor, head of private client and wealth management at Grant Thornton.

Once you have settled on an appropriate split across asset classes, it is important to diversify within each class, he says. “For equities, most investors should be invested in hundreds or even thousands of the world’s largest companies. This allows investors to diversify across regions, industries, currencies, and gain exposure to our changing world over their investment timeframe. Diversification within their bond holdings may involve exposure to government and corporate bonds, developed and emerging market debt, and bonds of varying durations.

“We would also have a strong bias towards diversification across property holdings, and not to be too exposed to one specific location or property type, such as retail, residential, commercial,” adds O’Connor.

Over the last decade it has been quite straightforward to construct a diverse portfolio. Today not so much.

“Central bank actions after the global financial crisis inflated the value of financial assets, with both equities and bonds producing significant positive returns. This meant a traditional portfolio comprising 60 per cent equity and 40 per cent bonds provided strong returns and generally met or exceeded investors’ return expectations,” says Brian Codyre, senior financial planning consultant at Mercer Ireland. “At the same time diversifying away from large-cap US equities to small cap non-US equities, or to alternative assets generally lowered returns over the same period.”

Now, however, factors such as geopolitical unrest, inflation and monetary policy suggest the return from a 60:40 portfolio may fall and, importantly, become more volatile over the coming years.

Says Codyre: “We are in a period of transition and there is a pressing need to take into account a widening range of political investment outcomes. Therefore, now more than ever we need to revisit how portfolios are structured and the role of diversification in supporting long-term goals.”