How a draw-down event can impact a concentrated investment portfolio’s return

We have been reminded in the last six months that risk assets from time to time can perform in a volatile and even an aggressive manner, and that valuations do matter. At the conclusion of the first quarter investors, especially those with a heavy exposure to equities for example, may well have been pondering why they have a concentrated investment portfolio over a more diversified approach. While the second quarter has resulted in quite a remarkable equities recovery, the question remains relevant. It was, for those with a shorter memory, only 12 weeks ago that investors with a heavy bias to equites were faced with a material draw down of ~-23% in the first quarter of this year.

We have witnessed over the course of 2020 thus far an immense bout of volatility, the likes of which many investors may have never seen before. So how have portfolios performed? There has been much ink spilt over time musing the pros and cons of a concentrated investment approach vs. a more diversified approach. Consider the following two investment approaches in the context of investment returns and how a material draw-down event can impact returns both short and longer term:

1. A concentred portfolio of investments within one asset class (say Australian equities). All good and well when a rising tide is ‘lifting all boats’, however not so great in drawdown events such as in the first quarter of this year.

2. A broader, Strategic Asset Allocation (SAA) approach, investing across all asset classes. In this instance, a ‘Balanced’* portfolio (60% growth assets).

How has a more ‘diversified’ portfolio, with a Strategic Asset Allocation overlay fared vs. the concentration of Australian equities (S&P/ASX Accumulation Index)?

For illustrative purposes, the following tables compare a ‘Balanced’* SAA portfolio approach vs. the S&P/ASX Accumulation Index over time. The lower table illustrates the impact to both short and longer term returns when there is a draw-down event that impacts an asset class and for completeness, the remarkable recovery in equities in Q2.

The return numbers highlight the change in overall returns when comparing them as at 31^st December 2019 and then again at the 30^th June 2020 after the Q1 draw down and the subsequent equities rally.

Both portfolio approaches reflect the impact of the equities draw down and the commensurate equities recovery in Q2. However, the impact for a concentrated portfolio creates a more material drag on both short and medium-term performance as depicted in the table above. At Providence, our focus for the last 20 years has been on the preservation of capital and a reasonable return above inflation. As such, we are strong advocates and practitioners of the diversified investment approach.