Investing in a risky world
There is a smart investment approach in the presence of such uncertainty. It is diversification: across asset classes, across regions and across industries. That way, whenever and wherever the next crisis hits, we are unlikely to have all our savings linked to its epicenter.
And there is one asset class that is very well-suited to diversification.
Take equities as a starting point. The rapid growth in market share of certain industries and companies is often the result of structural and cyclical tailwinds and, at times, a winner-takes-all environment. The tech sector has dominated the performance of the S&P 500 for a long time, but this year the degree of concentration in equity markets has been breathtaking. By the end of August the S&P 500 was up a respectable 10% year-to-date, but behind this was the five largest stocks, which had rallied 58% (in an equally weighted basket).
So, in equity markets there is a tradeoff that needs to be managed between diversification and upside return potential. That is not the case for bonds, in large part because most of the time there is not much upside to capture at all. If you invest in a company that becomes the industry leader, you will soon be drinking champagne if you own its shares but probably only the house red if you own its bonds. You see if you hold the bond to maturity you will simply receive your principle after having enjoyed the higher coupon payments that corporate bonds offer over government bonds.
While there is not much upside, the downside to corporate bond investing can be significant and comes in the form of loss in the event of a default.
This boring and unappealing risk/return profile is perfect for diversification purposes. This follows from the fact that there is not much of a tradeoff between diversification and upside return potential in a corporate bond portfolio. Diversification wins.
And a diversified corporate bond portfolio will reward you with a set of returns that are more stable than equity market returns and more resilient to unexpected shocks that fall disproportionately across industries and across countries.
The only genuine shield to the uncertainty we face in the years and decades ahead is diversification, and a well-constructed allocation to fixed income securities offers an optimal way to diversify exposures in a balanced fund across industries and across regions, while still providing an attractive relative return.
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