Is Portfolio Diversification dead?
One could think so given the extraordinary performance of equities over the last five to six years and the absence of a significant market correction.
The US equity market is likely to record its longest running bull market in August of this year, which is the longest period of time without a 20% or more fall in value. The equity market correction in February/March of this year ended a record period of historically low volatility for US equities, having experienced their longest period in history without a 5% or greater fall in value.
This is a theme picked up by Joe Wiggins in a recent post on his Blog site, Behavioural Investment, titled “The Death of Diversification”.
Wiggins proposes that the success of equities over the last few years could be used by some to argue as evidence of the failure of portfolio diversification. Furthermore, such has been the superior performance of equities that some could argue “prudent diversification” is no longer important.
The benign environment could well lead some to believe this, reflecting there has been “scant reward” for holding other assets. Diversification has come at a “cost”.
Of course such a worldly view, if held, is rubbish.
Wiggins does not hold these views. He does however indicate it is hard in this environment to argue for the benefits of diversification.
Nevertheless the benefits of portfolio diversification still exist.
It is not a time to become complacent, nor suffer from FOMO (Fare of missing out).
Building robust and truly diversified portfolios will never go out of fashion.
This is well summed up in Wiggins’s post:
“The idea of diversification is to create a portfolio that is designed to meet the requirements of an investor through a range of potential outcomes – it should be as forecast-free as possible. It is also founded on the concept of owning assets that not only provide diversification in a quantitative sense (through low historic correlations) but also sound economic reasons as to why their return stream is likely to differ from other candidate asset classes. Crucially, in a genuinely diversified portfolio not all of the assets or holdings will be delivering strong results at any given time, indeed, if all of the positions in a portfolio are ‘working’ in unison – it will feel like a success but actually represent a shortcoming.
I like the turn of phrase: as forecast-free as possible.
In my opinion, a portfolio still needs to be dynamically managed and tilted to reflect extreme valuations and a shifting economic environment, the focus should be on factors rather than asset classes.
Invest like an Endowment, seek true diversification and always remember the long-term benefits of diversification. The portfolio should be constructed to meet an investor’s objectives “through a range of potential outcomes”.
There would appear to be a diverse range of likely economic and market outcomes currently.
Robust portfolios are positioned for a range of outcomes and “forecast-free as possible”.
We all know a robust portfolio is broadly diversified across different risks and returns. Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.
I’ll leave the final comment from a great post from Wiggins:
“At this point in the cycle the temptation to abandon the concept of prudent portfolio diversification is likely to prove particularly strong; but unless a new paradigm is upon us, investors will be well-served remaining faithful to sound and proven investment principles. Take the long-term view and remain diversified”
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