One of the lasting impacts 9 years after the global financial crisis is ultra-low interest rates. This is great if you are a borrower, but not great if you are a saver – because if you avoid risk today, your returns will almost certainly be very low, and potentially lower than inflation. But if you take more risk today in the pursuit of higher returns, there is the possibility of being worse off if equity markets sell off.
Bear markets can be very detrimental as one might be forced to sell at the bottom – because of poor health, changing family circumstances, needing to fund living expenses in retirement – and this turns a paper loss into a permanent loss. Therefore, managing risk has never been more important for those seeking financial security.
An active asset allocation process focussed on your return objective; building a more diversified portfolio by including sometimes difficult to access asset classes; and, incorporating explicit downside protection are crucial to achieving retirement goals.
“Intelligent diversification is about firstly ensuring that you’re examining the underlying drivers of returns and ensuring diversity amongst the assets that you’re investing in, so that you have a collection of distinctly unrelated investment opportunities.”
Who should focus on diversification?
Typically, the longer your investment time horizon and tolerance for short term volatility means you can afford to have less diversification. (There are exceptions to this generalisation.) It is vital to take a longer term view when your biggest asset is future income and your focus, quite rightly, is on building your career. Time in the market, dollar cost averaging, compound interest and the earnings growth of companies are powerful allies to maximising savings.
This begins to change as your ability to recover from losses starts to diminish around the lead up to retirement. Balancing sequencing risk (a negative return when your investment portfolio is large and you need to withdraw money to fund your living expenses) and longevity risk (the risk of outliving your savings) becomes crucial. As you enter your 50s, with retirement likely still some way off, your assets are much larger and decisions need to be made around protecting what you have built while prudently growing it to ensure it lasts for as long as possible.
For investors approaching or already in retirement, the focus often shifts from maximising returns to minimising risk and targeting a specific level of return – “certainty of returns” is important. For an investor who is looking for increased certainty of returns, it is important that no single investment position should be allowed to put your overall portfolio’s investment objective at risk. This is where diversification - and risk management, not risk avoidance - can provide peace of mind to enjoy life leading up to, and during retirement.
“For an investor who is looking for increased certainty of returns, it is important that no single investment position should be allowed to put your overall portfolio’s investment objective at risk.”
Most people who should be diversified are not (even if they think they are)
According to the Australian Bureau of Statistics, the typical Australian household has 55% of their wealth invested in residential property, 20% invested in superannuation, 13% in direct shares, 9% in bank deposits, and 3% in other tangible assets (e.g. cars). On a look through basis, almost two thirds of people’s wealth is linked to housing via direct exposures or via Australian banks which have 60% of their loan books exposed to Australian residential housing.
This has been an exceptional portfolio to hold given Australia has avoided a recession for 26 years. However, it is also a highly concentrated portfolio and may be sub-optimal given today’s starting point – i.e. residential property is expensive (on almost all valuation metrics) and Australian household debt to disposable income is the second highest in the world. Diversifying portfolio risk should receive a lot more attention than it currently does.
Should I hold more bonds in my portfolio as I approach retirement?
The traditional approach to building multi-asset portfolios is to diversify risk by investing in bonds to offset the volatility of equities and to hold more bonds when approaching retirement. Falling share markets are typically associated with a weak economy, declining inflation and heightened risk aversion. Bonds typically perform well under this scenario, as bond holders receive a fixed payment stream irrespective of economic conditions; making them a reliable part of the portfolio. Therefore, a combination of growth assets (i.e. shares) and defensive assets (bonds) has the potential to deliver more consistent returns.
However, the fixed payment stream of bonds, which until now has been a source of reliability, is now the asset class’ weakness. With record low bond yields, investors are receiving lower income than ever before, and face the risk of interest rates rising leading to capital losses. A 1% rise in interest rates for a ten year bond has the potential to erase three years of income at current yields.
With this in mind, investors should be very wary of deeming something to be “defensive” irrespective of the market price. The level of risk of any investment is largely determined by the relationship between the price of an asset and its intrinsic value. Unless you believe inflation will remain low indefinitely, bond yields should eventually rise. Bonds can be defensive (i.e. protect against deflation), but can be a source of risk too.
“A 1% rise in interest rates for a ten year bond has the potential to erase three years of income at current yields.”
What could happen to my portfolio’s diversification if bond yields rise?
Equities may perform well if bond yields rise (prices fall) due to improvements in economic growth provided that is reflected in earnings growth. One scenario is that an investor may experience low returns from bonds (or slightly negative returns) but that this is more than offset by the performance of equities. If this is the case, then the benefits of portfolio diversification will largely remain intact.
However, we may experience a period when bonds are no longer a diversifier of equity risk, and are instead the source of risk. Higher bond yields increase borrowing costs for companies, increase mortgage repayments for individuals and possibly undermine stretched valuations of equity markets. In fact, many seemingly unrelated asset classes (infrastructure, property, equities, etc.) have valuation processes which use bond yields as a starting point to discount future cash flows, making them susceptible to higher bond yields.
Robust portfolios must be able to cope with:
- Low returns from bonds, including possibly negative returns if bond yields rise from here, and
- Potentially higher correlations between bonds and other asset classes, including equities.
What can we do to improve diversification?
To maximise portfolio diversification, having access to the widest range of asset classes is important. Unfortunately, many investors find it difficult to access the types of investments that fall between the cracks of more defined asset classes like cash, share and bonds. Investments such as emerging market debt, commodities, and alternatives all have a role to play. In addition, it is important to actively manage exposures which impact returns but are not asset classes per se, such as foreign currencies and stock selection.
To implement true diversification requires the ability to regularly and consistently compare a broad range of investments with their various expected returns and risks. The optimal approach to diversification is about ensuring your exposures to sources of returns are genuinely diversified. Some investments which appear at first glance to diversify portfolios, may in fact have the same underlying drivers of risk, or drivers of returns - many of which are not immediately obvious.
Today, many markets have valuations which are stretched, so maintaining adequate diversification is a key challenge and each of these return sources should be sized in a meaningful allocation.
“Some investments which appear at first glance to diversify portfolios, may in fact have the same underlying drivers of risk, or drivers of returns - many of which are not immediately obvious.”
Look through asset class labels to what drives risk
In addition to having a broad exposure to different sources of return, it is important to look through asset classes which appear diversified from the outside to identify those which have the same underlying drivers of risk, and to manage those risks independently. For example, investing in “credit” is a term used to describe lending to companies. Credit securities can be fixed or floating rates. Fixed rate bonds are sensitive to changes to the general level of interest rates in the economy whereas floating rate credit securities are not. It is important to separate out the type of exposure you wish to invest in (credit or duration) and then control your portfolio’s sensitivity to each separately. If your view is that interest rates will rise, you may wish to hold more floating rate than fixed rate securities or invest in fixed rate credit securities while reducing the amount of government bonds you hold elsewhere. In other words, the portfolio needs to be considered as a whole.
By the same token, commodities is one asset class that may be seen as a source of diversification. However, indirectly, many Australian investors have significant exposure to hard commodities (like iron ore) via their equity holdings or those of their superannuation fund (for example, by holding shares in BHP Billiton or Rio).
As such, rather than simply investing across the whole commodity market, an investor could tailor a specific basket of soft commodities to invest in (for example, cotton, wheat, sugar) which then complements the existing portfolio, avoiding ‘double up’ and therefore ensuring genuine diversification.
Active management can be an important diversifier
A “relative value” strategy is simply an investment technique which seeks to exploit a mispricing between securities within a particular asset class or market. One example of “relative value” investing is long short equity. Long short equity can profit from both stocks going up (long) and stocks going down (short). If the long short fund is “market neutral” then the returns depend on the skill of selecting stocks and not on the direction of the market. Actively managing FX is another source of “relative value” (owning one currency versus another currency), and there are often relative value opportunities in fixed income and credit markets.
“As the number of managers in each asset class increases the very thing investors want – alpha – is being diluted.”
Is it possible to over-diversify?
Diversifying managers with different styles and approaches makes sense in theory. However, as Yogi Berra once quipped, “in theory there is no difference between theory and practice and in practice there is”.
The problem is not apparent when an investor allocates meaningful amounts of capital to the fund managers they have high conviction in. However, there are limits to how cheaply true skill in stock selection is made available. High quality fund managers with long term track records of delivering outperformance often attract much investor interest, so placing a limit on assets under management may be necessary to preserve the fund manager’s ability to outperform. Consequently, as they grow, investors may face a situation of capacity constraints with their preferred fund managers, and they may begin to add new managers who they have less conviction in.
As the number of managers in each asset class increases the very thing investors want – alpha – is being diluted.
Don’t diversify your portfolio diversifiers
It is important to maintain meaningful exposures to portfolios diversifiers – alternative investments, unlisted property, unlisted infrastructure, active management, foreign currencies, etc., and resist the urge to dilute these exposures under the auspices of diversification.
Putting it all together
Intelligent diversification is about firstly ensuring that you’re examining the underlying drivers of returns and ensuring diversity amongst the assets that you’re investing in, so that you have a collection of distinctly unrelated investment opportunities. These investment opportunities need to be scaled appropriately to ensure that they are material for the outcome of the portfolio. Finally, it’s then about making sure your allocation to these investments is flexible and able to change as quickly as the prospective risk and return of holding those investments changes.
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Thank you for the article, very insightful. It would be interesting to understand what a model / example SMSF portfolio would potentially look like that can achieve the level of diversification that you consider appropriate.
Thank you for an informative and timely reminder. I wonder: With Australian household debt to disposable income being the second highest in the world, which country tops the ladder?
I agree with Jonathan Berry. I would be interested in what Michael Day suggests for SMSF