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Making the most of diversification

  • 06Nov 17
  • Mike Brooks Head of Diversified Multi-Asset Strategies

The bond bull market has supported returns from traditional balanced portfolios over the past 30 years. But with bond yields at extremely low levels the bull market could well be coming to an end, meaning this tailwind could transform into a headwind in the coming years.

The problem this presents is not insurmountable, however. Diversification - once memorably defined as the one free lunch in investment – can moderate the negative effects of a bond bear market. Most investors could dramatically improve their long-run returns and/or reduce risks by having a more diversified portfolio.

Diversification opportunities abound, because a far broader range of investments is readily available to investors than there was in the past. Examples include asset classes such as emerging-market bonds, infrastructure, property, high-yield bonds, loans, asset-backed securities, insurance-linked securities, litigation finance and marketplace lending.

Diversify, but do it effectively

It’s said that you can’t teach an old dog new tricks, and the same applies to many investors who have become set in their ways and closed to new ideas. On the other hand, some are all too ready to jump on the latest bandwagon without performing adequate analysis.

In an investment universe that is constantly changing, some of the most fruitful investments are those that initially appear to be “outside the box”.

The successful investor must navigate a sensible path between these extremes. In an investment universe that is constantly changing, some of the most fruitful investments are those that initially appear to be “outside the box.” But conventional investments are attractive to many for their perceived lack of reputational risk for the investor. Demonstrated by the old adage, “no one got fired for hiring IBM,” such caution is likely to limit investment returns.

Neither is buying blindly into the next big thing to be recommended. The South Sea Bubble and Tulip Mania are just two examples of investment fads that quickly went sour. More recently, the dot-com bubble was a classic example of investors believing ”it’s different this time” and, as a result, suspending normal investment discipline. Rigorous, thorough research and ensuring that the underlying investment case makes sense are the keys to success.

This process can be fiendishly complicated for the amateur investor, however. Warren Buffett once said, “Investing is simple, but it is not easy.” It is therefore important to invest with managers who have the breadth and depth of research capabilities to make sound investment decisions, despite the fact that their advice comes at a cost.

Nevertheless, the fees charged by asset managers have come under pressure in recent years. In many cases, this pressure is justified. For too long, too many managers have charged high fees without adding value. The seemingly inexorable rise of low-cost index-trackers is a natural and understandable response.

However, there remains a danger of the baby being thrown out with the bath water. Focusing excessively on low fees restricts the investment universe to equities and government (or investment-grade) bonds. This is a precarious strategy to employ at a time when the long-term prospects for these asset classes do not look good.

Adopt a long-term view

Investing for the long term should be another priority for investors. While it sounds like an obvious strategy, few put this approach into practice. It is difficult to resist the lure of news detailing short-term macroeconomic or earnings data, and the belief that we can trade successfully on it. This era of information overload is hard to resist.

Often, though, this short-term news is just noise – and can be more harmful than helpful when pursuing good long-term returns. Instead, we should disregard it; focusing on the primary drivers of returns over medium- to long-term horizons can lead to better investment decisions and better long-term returns.

Benchmark comparison is another area where investor short-sightedness can prevail. Increasingly, investors have tended to focus on risk relative to benchmarks and comparison with peer groups, typically over periods of less than three years. This approach is completely understandable. After all, if investment managers’ performance is judged against index benchmarks, those managers want to mitigate their risk of being fired.

But at the same time, it is a myopic approach, leading investors to lose sight of their key goals of good long-term returns while managing the risk of capital loss. Short-term performance can rely heavily on luck, rather than skill. To get a more accurate reading on a manager’s skill, performance should be evaluated over periods of five years or longer.

Many investors judge a manager based on their recent performance. This can be misleading:

Successive academic studies have shown that a focus on short-term performance often leads to investors firing managers with poor recent performance and hiring those with good recent performance. The net effect is a significant escalation of transaction costs - unaccompanied by an improvement in subsequent performance. The lesson? Focusing on short-term performance may be bad for your wealth.

Behave rationally

The investment industry depends more heavily than ever before on risk models – a natural consequence of the evolution and development of computational power and statistical analytics. But this has resulted in many investors relying on backward-looking models that focus on the short term, and encourages them to treat investment risk as something that can be statistically measured with precision. However, much of this output may be spurious. When it comes to risk in investment markets, not everything that can be measured is important - and not everything that is important can be measured.

Investment markets are driven by human responses to events and governed by the behavior of other investors. Or to put it another way, by the madness of crowds. Markets can move very quickly from relative calm to chaos. It is therefore crucial to develop a forward-looking perspective on risk. An investor must be clear on how much money he or she is prepared to lose - and over what timeframe.

The behavioral biases that permeate investors’ decision-making can often give rise to attractive investment opportunities. The ability to take advantage of these opportunities will depend both on the ability to adopt a flexible investment approach and the fortitude to take a contrarian position.

The aforementioned diversified approach can help: effective diversification should ensure that you haven’t suffered the same pain as your peers in any market reversal. This can equip you with the psychological strength to consider adding on weakness.

In investing, we are often our own worst enemies. We are all prone to various behavioral biases that can result in poor investment decisions. The best we can do is to try and be aware of these biases and employ disciplines to mitigate them.

Important Information

Diversification does not ensure a profit or protect against a loss in a declining market.

ID: US-130917-45621-1