How to diversify your client's portfolio

In this new age of technology, we have many tools to help us diversify our portfolios including quantitative models, a huge array of asset classes that we can access with one click and the ability to look back and learn from our mistakes.

However, as recent history has shown us, diversification is not always as simple as separating your eggs between baskets.

Diversification: An Empirical Case

Diversification is by no means a new concept.

In fact, Ancient Chinese merchants would divide their shipments across several different vessels. That way, if one ship were to sink or be attacked by pirates, the rest stood a good chance of surviving. 

Fast forward a few centuries and in a paper published in 1952, Harry Markowitz introduced the concept of Modern Portfolio Theory and the Efficient Frontier to the world. 

The overall framework of these theories is best illustrated using the simplified graph below:

The dots in the graph represent portfolios with a varying mix of bonds and equities.

The ones which make up the dark green line have a correlation of +1, that is, the bonds and equities are 100 per cent positively correlated, hence the straight line between a portfolio of 100 per cent bonds and 100 per cent equities.

As we diversify the portfolios, or reduce the correlation between the assets, the dots shift to the left. This implies that we can achieve the same level of return with a lower risk, or equally, a higher return at the same risk level.

The basis of this concept is fairly straightforward: as you reduce the correlation between assets in your portfolio, you reduce the magnitude of idiosyncratic risk (the risk associated with single assets).

The Traditional 60:40 Allocation

The example above may seem simplistic but for many years after Markowitz published his paper, investment funds measured themselves against a 60:40 split, that is, 60 per cent allocated to equities and 40 per cent to bonds.

This asset mix provided a well-diversified portfolio, and hence, a good risk-adjusted return.

However, in the aftermath of the 2007/08 financial crisis, central banks began aggressive monetary easing policies, reducing developed economy base rates to virtually 0 per cent and buying huge amounts of bonds as part of quantitative easing programmes, reducing yields further.

This low yield environment has meant that investment grade bonds offer little in the way of income and with less room for yields to fall further, the potential for bond appreciation through future price increases is diminished. With a portfolio consisting of 40 per cent in bonds, this may cause a drag on performance.