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Diversification, but not as you know it

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Managing in a sea of uncertainty

Diversification, but not as you know it

Harry Markowitz coined the phrase in 1952 that diversification was the ‘only free lunch’ in investing, meaning diversification is a benefit without cost. Over the past 20 years the availability of asset classes, from owning forestry to leasing aircraft, has expanded rapidly and it is no longer clear how to benefit from diversification.  

Diversification is when investors benefit from assets performing in different ways at different times to balance overall portfolio risk and reward. The key behind diversification is the way assets behave or, in other words, how they correlate to each other.  

Traditional assets, such as government bonds and equities, are a good example of two assets that have behaved differently and have experienced a negative correlation, so when one asset rises in value, the other falls. This balancing effect helps improve portfolio risk and return metrics over time, providing a shock absorber for portfolios. It sounds simple.  

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One of the issues that investors face is the blurring of what diversification means. Everyone will have seen presentations with lots of different assets and the presenter highlighting how diversified the portfolio is. Much of the time the diversification benefits are marginal, as the assets are still affected by the same market influences. The key is to understand and diversify the market risks that influence each asset.  

Adding assets that sound like they will add diversification, such as a bond fund, will not necessarily help. Not all bonds behave in the same way and they have different correlations, so you need to be careful with generalisations.  

On top of this, the interpretation of data is important. If you view two assets over a one-year period and they rise in value together (high correlation), you could misinterpret this as an indication that they have similar market drivers and risks. Yet it could just have been coincidental that they both rose in value that year. You should therefore also look at beta alongside correlation to have a better understanding of risk and correlations.  

The big issue for investors at present is that correlations and market influences change over time. For the past 30 years, equities and government bonds have had a negative correlation. It makes sense that they have a negative correlation, as equities generally fall in value in times of stress.  

The reaction of central banks and bond investors in times of stress has been to reduce interest rates or reduce the future expected level of interest rates, causing bond values to rise. The concern going forward is that the stress could be caused by rising interest rates.  

In that environment, both equities and bonds could fall in value. We did see a glimpse of this in May 2013 when Ben Bernanke, then chairman of the US Federal Reserve, suggested that the Fed would taper quantitative easing and look to raise interest rates.  

The result was that both equities and bonds fell. If you thought your portfolio was diversified because you had equities and bonds, you were nursing some losses greater than you thought possible because correlations changed.