Actions for diversifying your portfolio effectively
Low interest rates and quantitative easing have made diversifying a portfolio more complex. But there are a few rules which can help you build a resilient portfolio, diversifying risks across a range of investments and avoiding nasty surprises.
IN A FEW WORDS
Diversifying Diversified portfolio Diversified investments Diversification in investing Diversifying risks
4 min reading
When it comes to investments it is generally a mistake to rely on a binary outcome, to place all your investing eggs in one basket. In the time before zero interest rates and quantitative easing, achieving a diversified portfolio without this binary risk was easier; investors could have a blend of shares and bonds and their portfolio would weather most storms. However, today investors need to work a little harder to ensure their diversified investments are resilient.
The monetary policy environment that has prevailed since the Global Financial Crisis of 2007/8 has created some complexities. It used to be, broadly speaking, that stock markets would do well when economic activity was high and bonds would do well at times of recession.
Low interest rates and quantitative easing brought bond and equity returns closer together. Rather than move independently, both asset classes increasingly correlate to falling interest rates and quantitative easing. As such, many of the normal strategies to achieve diversification in investing have been less effective. The average bond and shares portfolio would move up when rates dropped and quantitative easing resumed then fall when central bankers changed tack.
A diversified portfolio needs a good range of assets
With this in mind, the first rule of a properly diversified portfolio is that it should have a blend of assets beyond simply bonds and shares. If 2020 showed anything, it is that markets are inherently unpredictable and investors need to be prepared for a range of outcomes. The exact blend will depend on your own age, stage and attitude to risk.
That’s not to say that investors can ignore the markets. In the current environment, for example, high quality government bonds may be a useful way of diversifying risks, but they pay little income and there is limited scope for capital growth. It may be worth looking for other asset classes that can fulfil a similar role in a diversified portfolio, such as infrastructure or specialist property.
Energy prices can affect different assets in different ways
Diversifying is about more than just the economic environment and whether stock markets go up and down. It is also necessary to ensure that you’re not accidentally taking a binary position and exposing yourself to a market shock. This is relatively easy to do with energy prices, for example. Some sectors and markets are energy-dependent, while others benefit from high energy prices.
In some cases this is obvious – aeroplanes use a lot of fuel, for example – but in others it is not so clear. The Indian stock market, for example, tends to be a beneficiary of low oil prices as India is a net importer of oil. Equally, oil is a significant input cost for many mining companies, so they may benefit from lower prices.
Investors need to ensure that they are not subject to a sudden energy price shock because all their portfolio is geared to lower energy prices. Oil shares have become unfashionable in a world increasingly focused on carbon emissions, but they can be one way of diversifying a portfolio if it is otherwise focused on energy-dependent sectors. Specific emerging markets – Russia and Brazil, for example – may also be on the other side of the trade.
Interest rates are an important consideration for income investors
Interest rate changes are a peril for any income investor. Assets that pay an income have a natural relationship with interest rates. If an investor can get an income of 4% from cash, chances are that they won’t want to risk less predictable income from the stock market. If the income available on cash drops to 1%, inevitably the 4-5% available from shares becomes more valuable. As such, it doesn’t really matter which sector you’re invested in, it may fall with higher interest rates and vice versa, at least in the short-term.
There are other considerations too. Gold often does well when interest rates are low, for example, because it doesn’t pay an income and therefore there is less ‘opportunity cost’ to holding it.
By making sure their portfolio isn’t all pointing in the same direction on interest rates, investors can help to avoid facing significant losses should interest rates rise. That may mean drawing income from a spread of assets.
It can also mean building in some inflation protection – looking for companies with a track record of growing their dividends. The UK investment trust sector can also be a good hunting ground: the Association of Investment Companies’ ‘dividend heroes’ all have a track record of growing their payouts to investors for 20 or more consecutive years.
It doesn’t have to be value versus growth
Certain stock market sectors are more dependent on economic growth than others. In general, these ‘cyclical’ sectors have been very out of fashion in recent years, while companies that can grow in all economic environments have been prized by investors. It’s always difficult to know when the market is likely to turn. We are currently in a market that favours economically sensitive companies as investors are expecting a recovery. However, that could change should there be problems with the Covid vaccine rollout or if powerful new variants emerge. Again, it is worth having a balance across both types of company in the long-term to achieve truly diversified investments.
The aim of diversifying effectively is not to neutralise all risks in the portfolio, but diversifying risks to make sure you are prepared for different eventualities. It also helps to ensure that the risks you take are the ones you want to take and there are no nasty surprises
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