Diversification in Correlation Street

The same old terms seem to be repeated by people in the investment industry, and “diversification” is one of them. In simple terms, it means to avoid putting all your eggs into one basket. But why is it so important?

The risk of investing everything in equities

Most investors understand that investments can go down as well as up, so placing everything in one investment is a massive risk. Even spreading the investment across global equities might not be sufficient diversification to avoid the fluctuation of prices, especially over the short- or medium-term.

For example, investors who kept all their money in equities between 2000 and 2013 would not have achieved higher returns than other investors who had kept all their money in cash over the same period.

Introducing bonds
The standard way of coping with the uncertainty of equity returns is to include an allocation to bonds that have a high credit rating (such as UK government bonds). Equities and bonds provide good diversification when their prices move in opposite directions or, to use the technical term, when these assets have “negative correlation”.

However, these broad asset classes tend to move in the same direction, i.e. positive correlation, often in response to rising inflation.

To explain, rising inflation means an increase in the speed at which the prices of goods and services are going up. In order to keep inflation at a steady pace, central banks (such as the Bank of England) are likely to increase interest rates. This makes borrowing more expensive and saving more attractive. Hence less money is spent on goods and services which encourages their prices to rise less quickly or to fall. Furthermore, saving is seen as a relatively low-risk investment. So if the return on saving goes up then money is likely to be moved into savings from other more risky investments such as bonds and equities. Therefore, the prices of bonds and stocks are pushed down: i.e. there is positive correlation between the price movement of bonds and stocks.

Further diversification
A diversified approach can provide a solution to this problem. By spreading the range of investments within a portfolio, the correlation of movement between them is reduced. The assumption being made is that the asset classes included within a portfolio have the potential to produce attractive long-term returns. So the intention is to create a portfolio in which, during a market downturn, some assets should be better placed to retain their value or even rise while others are falling i.e. there is negative correlation between the assets in the portfolio.

A recent example
During the financial crash of 2008-9, the prices of riskier assets such as stocks and corporate bonds fell and many “alternative” investments such as hedge funds made huge losses. But while the value of emerging market (such as countries in Eastern Europe, South America and Asia) equities dropped 30% in 2008 alone, the value of some emerging market bonds rose 30%.

Obviously, this was beneficial to those investors who had diversified their portfolios sufficiently to include these growing assets. And they weren’t alone. Other specialist and rather obscure asset classes such as “catastrophe bonds” (bonds that deliver a positive return if there is no catastrophe) and “managed futures” (a complex investment run by professional money managers) also delivered positive returns during this period. In fact, we estimate that there are around 20 asset classes that show reduced or even no correlation with mainstream financial markets.

Other benefits
Investing in a broad range of asset classes can also make it easier for an investor to release cash where necessary. What’s more, diversification can reduce fluctuation in the value of the overall portfolio: where one asset class falls or rises, others might not.

Too much of a good thing
However, excessive diversification, while reducing the volatility of your portfolio, can also dilute your returns. The key is to strike a balance between having high conviction in the assets that are included, while making sure that the level of risk inherent in the investments balances out to produce an overall level of risk that is appropriate for the investor in question.

Some investors might feel they don’t need multi-asset investing because they can confidently predict the direction of financial markets. Perhaps they adopt a more optimistic view and take on a higher level of risk by investing primarily in equities, or a less optimistic one by investing in government bonds.

The trouble with this approach is that markets are currently demonstrating a high degree of volatility, making prediction especially difficult. Also, there is divergence among central banks with some looking to increase interest rates while others are reducing them, and the oil price has fallen to a quarter of what it was in mid-2014. What’s more, China which consumes around a third of global exports, is experiencing a slowdown in the rate of its economic growth, while weakness in other emerging markets is spooking investors.

So for investors, now is as good a time as ever to diversify.

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