Investments  

How to diversify your client's portfolio

  • Describe what conventional diversification is
  • Explain why that is not working now
  • Identify other forms of assets that can be used to diversify a portfolio
CPD
Approx.30min
How to diversify your client's portfolio

The age-old saying to not put all of your eggs in one basket is a principle that many investors follow when it comes to their investments.

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.

More Asset Classes = Better Diversification?

Given the current market environment, achieving the same level of risk-adjusted performance is becoming more challenging with the traditional 60:40 split.

As such, many investment managers now include a variety of asset classes in their portfolios. This may include real estate, private equity, commodities and so on. 

CPD
Approx.30min

Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

  1. What was the typical asset allocation between asset classes, following Markowitz's study of diversification?

  2. Why are investment grade bonds offering little in the way of income?

  3. What was one of the advantages of the financial crisis to the investment sector?

  4. Which of the following is NOT considered to be a hedge against a downturn?

  5. Which of the following is NOT an additional layer of diversification?

  6. ETFs can provide low-cost, liquid exposure to a wide variety of markets, true or false?

Nearly There…

You have successfully answered all the questions correctly, well done!

You should now know…

  • Describe what conventional diversification is
  • Explain why that is not working now
  • Identify other forms of assets that can be used to diversify a portfolio

I completed this CPD in

To bank your CPD please complete the form below.

Were the stated learning objectives met?

Why weren't they met?

What did you learn from undertaking this CPD exercise?

Why did you undertake this piece of learning?

Banked!

Congratulations, you have successfully completed and banked this piece of CPD

Already Banked!

You have already banked for this article.

To bank your CPD you must or

Register

One or more questions have been incorrectly answered,
 please review your answers and try again.

Please complete all the above text fields to bank your CPD.

More Investments CPDSee my completed CPDSee all CPD