Why diversification matters for income generation

The reason diversification is always being talked about is because all too often people are not listening: portfolios are heavily skewed towards one fund or asset class, or maintain a huge home bias instead of having a geographical spread.

And, in essence, the principles of diversification are relatively simple.

Bob Szechenyi, investment director for Rathbones, explains: "Generally speaking, it boils down to not putting all your eggs in one basket and not concentrating your risk.

"‘Income’ is an important part of meeting life goals such as school fees or retirement, which is why we want to make sure it is long-term and sustainable, and from a diversified source, with differing geographical and/or currency exposures."

He says this can help during times of market distress, when it is important that all assets are working for you but in different directions.

Why diversify?

It seems simple enough - so why should this mantra be one that is repeated often? And why should it matter in an income portfolio?

Patrick Norwood, insight analyst for Defaqto, comments: "Diversification is, of course, important in any portfolio. 

"All the various potential asset classes tend to do well and badly at different times in the investment cycle, therefore having the portfolio spread across several asset classes will smooth its volatility while still maintaining a decent return."

Quite simply, if one knew in advance the sequence of returns that would come up in the planning horizon, one would compute the PWR, withdraw that amount each year, and reach the desired final balance exactly and just in time. 2017 York University study

But when it comes to income, Joe Roxborough, chartered financial planner for Ascot Lloyd, says it is "even more important".

He explains: "When using a portfolio to provide an income, your investments need to provide [clients] with a steady stream of returns, rather than big ups and downs, which is precisely what diversification seeks to achieve."

And yet if investors only hold a "safe as houses blue chip that reliably pays out steady dividends", Mr Roxborough says this is setting the portfolio up for a big fall. What if the company "has hidden pension deficits, or behind-the-scenes management issues that could cause huge issues soon?"

There is no point chasing income from just a handful of stocks, no matter how big and bold and beautiful the dividends. 

Nor is it enough to focus purely on government bonds (especially with yields so low across all durations), or even fixed income stocks - the risks of over-relying on steady income-earners are just too great.

True diversification

Tim Morris, IFA for Russell & Co Financial Advisers, says it is "critical" to have diversification within an income-generating portfolio, especially if someone is seeking to live off the income and make regular withdrawals as a result.

Mr Morris highlights a study from the University of York last year (2017), authored by several experts including Andrew Clare, in which it found that diversification across asset classes does lead to higher withdrawal rates than simple equity/bond portfolios.

The 36-page study, called Decumulation, Sequencing Risk and the Safe Withdrawal Rate: Why the 4 per cent Withdrawal Rule leaves Money on the Table, built upon earlier studies which aimed to work out the perfect withdrawal rate (PWR). 

It claimed in a perfect world, all advisers and investors would have to do is a simple equation that would allow them to find out exactly how much money could be taken from the fund each year, without detrimental effect.

The study said: "Quite simply, if one knew in advance the sequence of returns that would come up in the planning horizon, one would compute the PWR, withdraw that amount each year, and reach the desired final balance exactly and just in time."

However, we do not live in a perfect world but one of "unforecastable asset returns", which have a knock-on effect on any tactical glidepath to retirement returns, and resulting in costly failures to provide a well-balanced, risk-tolerant portfolio.

In essence, without proper diversification, taking down far too much income from a fund whose investment performance is unpredictable is a highly risky strategy, especially for people looking to live off the income from their portfolio.

Due to the difficulty in finding low risk assets with a yield close to the holy grail of 4 per cent, many fund managers have diversified away from typical fixed interest assets. Tim Morris

The study also concluded: "Using UK data we find that multi-asset portfolios for the most part offer an improvement on 60-40 (equity to bond ratio) and 23 30-70 stock-bond investments with smaller probabilities of low safe withdrawal rates.

"The exception comes for those seeking the very highest PWRs where there is little choice but to accept a large equity component."

While the study believes a 4 per cent annual withdrawal can work in the investor's favour, what really matters is true diversification - not just in terms of the bond/equity allocation, but across a wider range of asset classes and with an attempt to minimise exposure to trends.

"The application of a trend following filter to the assets within each portfolio substantially improves the performance by reducing volatility and maximum drawdown without any loss of return," the study concluded.

According to Rathbones, there are several overarching risks that the multi-asset team keeps a close eye on, aiming to diversify the portfolio so the underlying holdings are unlikely to all be affected from either systemic or management risks.

These are: 

• Systemic risks: Data security, changes in fashion, disruptive technologies, terrorism, and political intervention.
• Management risks: Controls failures, complacency, dissatisfied customers, consumer safety and compensation.

Moreover, there are certain themes each year that keep the investment team awake at night - these, too, have to be managed, as the following graphic suggests. 

For Mr Morris, the study's findings showed how difficult it really was to run a low-risk portfolio that would allow for decent drawdowns, without true diversification.

He explains: "Due to the difficulty in finding low risk assets with a yield close to the holy grail of 4 per cent, many fund managers have diversified away from typical fixed interest assets.

"Some are taking additional risk. This often isn’t suitable for income-seeking investors, who tend to be more cautious. They may well come unstuck, especially with volatility making a return and interest rates expected to rise."

Sequencing risk

True diversification is important for any portfolio, but when it comes to income-generating portfolios in particular, Mr Norwood believes reducing volatility is "especially important", when the client is factored into the equation.

"This is because income portfolios are normally used in the decumulation phase of the investment lifecycle, such as during retirement. 

"In this phase, money is being taken from the fund regularly. As a result, if the portfolio were to suffer a large drawdown, there is not the chance to make all of the money back through market rises in later years - which there would be during the accumulation stage."

These risks are known as pound-cost ravaging, or sequencing risk, and can have a deleterious effect on an income portfolio, especially in retirement, as the following graphs from Royal London illustrate.

The case study accompanying the below graph is that of a man called George, who is 65, and has a £100,000 pension pot. He requires £5,000 annual income from the portfolio - so no problems there regarding his annual allowance. 

Source: Royal London/Lipper

The horizontal red line indicates the average annualised return of the portfolio since 1975. The purple bars show the performance of the market each year.

Had George retired in 1975, and taken income every year at £5,000 a year, he would have seen great investment growth and no deleterious effects on his portfolio.

However, if George had retired in 2000, his fund would have seen a 40 per cent loss in the first three years; coupled with the effect of taking income, the damage to his portfolio would have been immense - and it is very difficult to recover from such a loss.

As the Royal London factsheet on pound-cost ravaging comments: "A diversified portfolio can help to smooth out the ups and downs of the market and reduce the effect of market falls, but it’s also important that the portfolio is designed with income provision in mind. And this means using the right risk target."

Hence Mr Norwood says there is a great need to avoid such losses on the fund in the first place through diversification, the right sort of income-generating strategy and reducing volatility, as much as there is a need to avoid high correlation between stocks, shares, investment themes and systemic risks.

simoney.kyriakou@ft.com