It is almost a given that should you approach your investment advisor for some financial advice, at some point in the conversation the word “diversification” will crop up. It is indeed good and standard practice in investment management that portfolios are well diversified. Numerous financial literature is available on the merits of diversification; it is indeed what modern portfolio theory is based upon.
Unfortunately naïve investors can get complacent and get caught in an artificial reality where they feel their investments are safe as long as they are diversified. The benefits of diversification are intuitively easy to understand, with the common saying “don’t put all your eggs in one basket” being the favourite way of portraying the principle. It is however imperative to understand the limitations of the risk mitigation benefits of diversification. Diversification addresses the idiosyncratic (individual) risk related to an investment, not the market risk. There is indeed therefore a limit to the power of diversification to lower risk, and diversifying beyond that limit is counterproductive as it would typically involve more fees, more time needed to monitor and manage your investment portfolio and more frequent rebalancing which will impact risk-adjusted returns.
Additionally, one of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. Correlations tend to increase in down markets, especially during crashes, diminishing the diversification effect of the portfolio. Studies have shown this effect to be pervasive for a large variety of financial assets, including individual stocks, country equity markets, global equity industries, hedge funds, currencies, and international bond markets. Moreover, diversification seems to work remarkably well when investors do not need it—during market rallies.
The 2008 financial crises is a clear example of the failure of diversification, where the inescapability of the collective downturn in financial assets offered little protection to investors. It is therefore imperative that during your risk evaluation process, you consider the how your overall portfolio would behave in a downturn using downside risk measures and scenario analyses.
To enhance risk management beyond naive diversification, investors should re-optimise portfolios with a focus on downside risk, consider dynamic strategies, and depending on aversion to losses, evaluate the value of downside protection as an alternative to asset class diversification.
The stock-bond correlation is a prime example of getting diversification right in the asset allocation decision. When market sentiment suddenly turns negative and fear grips markets, government bonds almost always rally because of the flight-to-safety effect.
In sum, your approach to portfolio construction shouldn’t be “the more the merrier”, but be based on historical or forward looking scenario analysis, stress testing the correlations in order to ensure you are not exposed to inadvertent risks. In addition, significant emphasis should be put on the stock–bond correlation and consideration of whether it will continue to be inverse in the future.
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