Back to basics: why diversification matters

Investors can’t avoid stock market volatility, but they can put up some defences. By observing a few sound investment rules that have stood the test of time, they should be able to create a resilient portfolio, fit for all conditions. Diversification is a good place to start.

The concept of diversification is straightforward and based on sound academic rationale, Nobel Prize-winning American economist Harry Markowitz’s Modern Portfolio Theory. Investors need to spread their portfolio across different asset classes, regions and sectors in order to smooth returns over time. By holding a range of assets, it’s more likely that if one part of their portfolio is struggling, another area may offer compensating returns. Governments bonds may perform well in times of recession, for example, while stock markets may do well when there is lots of economic activity. Combining asset classes with different characteristics - with low correlation to each other – can help to achieve better risk-adjusted returns.

This is great in theory – and used to be fairly straightforward in practice. At its simplest level, investors would need to buy a portfolio of bonds and a portfolio of equities. The equities would rise when times were good, and the bonds would give portfolio protection when times were bad. Many mixed asset funds were built using this simple formula.

Since the Global Financial Crisis, equity and bond markets have been distorted by low interest rates and quantitative easing. Both asset classes benefited from low interest rates, therefore the correlation between them increased. For many years, this was good. Both asset classes went up at once. However, the risks of this strategy have been seen recently as the interest rate cycle has turned and investors have seen equities sell off and their bond portfolios offer no protection.

This has been a particular problem for UK investors where the Government’s mini-budget on 23 September 2022 derailed the gilt market. Investors saw double-digit losses in an asset class that has typically been designated as ‘disaster insurance’.

Over the longer term, globalisation has seen greater correlation between regional stock markets as countries have become more interconnected. A consumer goods company in the US will look pretty similar to a consumer goods company in Europe, so investors aren’t necessarily getting diversification by investing in both. This has also made achieving portfolio diversification more difficult.

This changed environment doesn’t mean that diversification is wrong, just that investors need to be smarter about how they do it. The good news is that new investment products are coming to market all the time, and investors have an increasing range of tools to build diversified investments.

At the start of this year, with the post-Covid recovery well underway, few would have predicted the extent to which markets have been derailed by the Ukrainian crisis. Even fewer would have predicted that commodity stocks, infrastructure and gold would have been the places to invest. Diversification has been one of the few ways investors have protected themselves.

Investors can’t just buy different assets and hope that they will provide portfolio diversification. There’s more to it than that.

First, you don’t want a portfolio of stocks that are too correlated to each other, so it is worth looking at the beta of individual stocks. This shows the extent to which the share price is correlated with the wider market. A beta of 1 means high correlation, 0.2 would be low correlation and -0.5 would be negative correlation, meaning it’s likely to move in the opposite direction. 

You also need to look at the performance of individual assets in relation to other elements, such as interest rates or energy prices. Part of the problem for investors recently has been that prices for technology stocks and long-dated government bonds have both shown a strong relationship with interest rates. Equally, a well-balanced portfolio might hold both beneficiaries from higher energy prices (such as oil and gas producers) and those for whom energy is an input cost (such as airlines).

Inflation protection is another important consideration. Areas such as infrastructure have become popular with investors for their inflation-adjusted cash flows. In contrast, inflation-linked gilts have been a difficult investment this year, in spite of high inflation. Investors need to be careful on the price they pay for any ‘insurance’ for their portfolio. Gold has worked better as a substitute ‘disaster insurance’ for investors in the UK as the gilt market has proved volatile.

While assets will often correlate in the very short-term, particularly at times of market panic, they will behave differently over the longer-term. Bonds and equities have shown very tight correlation in recent years, but as the interest rate environment normalises, there is a chance that they will resume historic patterns and provide better diversification for portfolios once again.

Investors have more choice of assets today than ever before. Within the investment trust sector, they can choose renewable infrastructure, esoteric fixed income funds, specialist property or even peer to peer investing. These asset classes all offer options for diversification and can bring different characteristics into a portfolio.

Diversification is vital for portfolio stability, particularly in the current febrile market conditions. Investors may not get there with a bond and equity portfolio anymore, but they do have greater choice of alternative asset classes that can do the same job. It’s a sound investment principle that has served investors well for generations.

With your Fineco platform you can access a broad range of ETFs, indices and bonds across global markets and currencies. All through a single account with simple and transparent pricing.