Two ways to better diversify your portfolio

 

Advisers and wiser clients themselves generally try and run a diversified portfolio. As they say, diversification is only necessary when you don’t “know” what the future holds. And in the modern world, knowing what the future holds isn’t common knowledge. Will inflation take off soon? Will the US go to war with China over Taiwan? Will markets crash?

While we can put probabilities on all of these events, if we’re honest with ourselves, we don’t know for sure what will happen. And hence the reason to diversify is obvious. Diversification is essential protection against the unknown, and there is plenty of the latter to be concerned about.

Diversification has other benefits as well. It reduces the likely distribution of returns from a portfolio, better aligning portfolios with what investors really want including greater certainty of a good outcome.

Having established that without divine power or a great deal of overconfidence, we need to be diversified, how do we best go about achieving this for our portfolios?

The traditional way to diversify, which is still used almost universally today, is to add different assets to an equities portfolio that blunt the pain when equities are hit; otherwise known as the 60:40 portfolio or some derivative thereof. Defensive bonds and cash have historically held up better when equities fall and hence when combined with equities, provided historical diversification benefits. However, today the extremely low yields from bonds and cash along with stated policy intentions of higher inflation, mean that likely future returns and protection from bonds and cash are lower and more uncertain. And given that inflation is one of the bigger risks we face as investors today, we need to realise this poses a known risk to all long-duration assets. These include both typical bonds and equities, both of which pose the risk of no longer providing a diversified portfolio.

It is worth noting that while simple diversification seems rather easy, better diversification and risk management require more sophisticated portfolio construction and asset class knowledge, along with greater use of different alternative assets and strategies. Insight on asset class relationships and vulnerabilities at a point in time, and their likely relationship in the future, is extremely beneficial and helps differentiate a better risk-managed diversified approach from a more naïve one.

Diversification is so widely used because it is not only necessary due to its generally superior risk management and downside protection compared with a more concentrated strategy, but most importantly it tends to keep people and portfolios “alive” and “in business”. They don’t disappear off the map, often even when they are rather naive or suboptimal in their approach. It hence has more effectively protected against ignorance. As mentioned, in future this historical protection against ignorance is less certain.

However, the common approaches to building diversified portfolios come with one huge problem – they almost always provide a rather mediocre return outcome. This is why you see so many diversified funds, superannuation funds, and adviser portfolios perform unimpressively over the long run. While they have diversified and managed risk to some degree and reduced the risk of large downside, they have also removed the opportunity for outsized returns through time and hence removed the potential for a great return outcome. This is why you’ll rarely see sophisticated industry participants and industry insiders investing in typical “plain-vanilla” diversified approaches.

Simply diversifying across asset classes is available to everyone, almost universally used, and as such doesn’t and won’t, almost by definition, provide outsized or extraordinary returns over the long run. It is simply too average, and substantial wealth creation simply isn’t that broadly available. If we operated in a parallel universe with better governments and better-run economies with longer-term incentives than we have today, and there was no fraud, corruption or malfeasance, this could be different – alas, we don’t and hence need to be realistic about the world we operate in today, and the need to avoid the worst and seek out the best when investing our funds.

So, now we’ve established not only that diversification is necessary, but also that better diversification is needed because:

1. The world has changed with elevated asset prices and inflation now a bigger risk posing greater forward-looking challenges to traditional assets, and 
2. Simple diversification routinely fails to deliver great returns.

So, how can we take what’s good and improve upon what isn’t? How can we remain diversified but do it more sensibly with a more forward-looking outlook, creating higher returning diversified portfolios?

The answer is simple, but not readily available or “off the shelf”. We need to diversify in a more sophisticated and knowledgeable way. And we need to recognise that whatever we invest in, it needs to have higher return prospects. To achieve this, there are two obvious solutions that should be used in combination:

1. Invest more dynamically and more proactively in different assets. We invest when it is more likely we are at a more favourable point to do so, rather than simply investing in an asset forever and unrealistically expecting its properties and prospects to stay the same. A process that considers more favourable macroeconomic backdrops and thematics is just one example of how this can be done, an approach that beats the crowd and gets out before it.
2. Invest in diversified “alpha” sources. We invest in individual assets and strategies that are likely much better than their peers, and hence much more likely to perform well. We invest actively with the best global stock-pickers and pick the best strategies and managers in a timely manner, when they are most prospective. This approach provides breadth to a portfolio, making it a more reliable achiever.

In conclusion and in essence, a diversified approach is needed and necessary. But to provide greater returns and superior risk management, a more comprehensive strategy and significant active management skill must be used. This is not available from your typical diversified approach, and it won’t typically be found from those using only in-house asset management capabilities. It will rely upon diversifying among the very best of what’s available in the broader market, and doing so in a timely manner with good top-down knowledge and insights. If you’re able to access this - and why wouldn’t one want to? - then you’ll greatly increase the probability of doing extremely well while still keeping your downside risk low.

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