Diversification has been the central tenant of portfolio construction since the early 1950s.
Diversification simply explained, you don’t put all your eggs in one basket.
Nevertheless, technically we want to invest in a combination of lowly correlated asset classes. This will lower portfolio volatility. (Lowly correlated means returns from assets are largely independent of each other – they have largely different risk and return drivers.)
The article highlights that more asset classes does not equal more diversification.
“This is because the investment returns of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.
So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.”
From the Article
- Diversification is just one risk management tool, not a comprehensive risk management solution.
- Multiple asset classes won’t lower portfolio risk when the same factors drive each asset classes’ investment returns.
- Diversification cannot provide protection against systematic risk, such as a global recession, when all major asset classes tend to fall in unison.
Risk comes in many forms but investors are acutely aware of two: the impact of capital losses and extreme bouts of volatility.
Both can have a devastating impact on a portfolio.
Capital losses, such as we saw during the global financial crisis, may never be recouped by some unlucky investors. Meanwhile, volatility can prompt investors to withdraw their money at just the wrong time or quickly erode a lifetime’s savings when an investor is drawing down their capital.