Building resilient portfolios: The power of diversification
Article by Russell Investments, UniSaver’s investment consultant and manager
Summary
- Diversifying a portfolio means spreading the investments across a variety of asset classes, industries and geographies
- Diversification can help reduce the risk of a concentrated portfolio that would be vulnerable to news, an economic change, or market development impacting a specific asset class or geography
- Diversification can help smooth out a portfolio’s returns over time. UniSaver’s investment options are diversified across asset class, investment manager, investment style and securities.
Three simple rules
When diversifying your investments, remember to:
- Spread your money across the different asset classes: equities and fixed income
Each asset class has its own unique risk and return attributes. And because the risks of one asset may complement the risks of another, it may be possible to achieve higher investment earnings and reduce your portfolio's volatility by combining different asset classes. The investment options that UniSaver offers have targeted asset allocations to align with a member’s risk tolerance.
- Reduce exposure to any one investment style
Understand that value and growth equities, and sovereign and corporate fixed income securities also exhibit unique risk and return attributes, often dependent on the prevailing general market conditions at any given time. UniSaver’s multi-manager approach targets an optimised blend of investment styles to deliver returns across a variety of market conditions.
- Reduce "security-specific risk"
Purchase a broad range of investments across various companies and industries rather than a limited selection of individual securities. This way, no single investment will dominate the performance of your retirement account. The managed funds UniSaver invests into are built around this concept.
The concept of diversification is well-known. The adage “don’t put your eggs in one basket” highlights the essential role of diversification across many aspects of one’s life. But it is especially so in an investment portfolio that is intended to help fund a future goal—such as retirement.
Diversification is a strategic approach in which investments are spread across a variety of asset classes, industries, and geographies. This can help reduce concentration risk, which is when one asset class—or even a handful of securities—can come to dominate a portfolio. The problem with holding a concentrated portfolio is that it is vulnerable to any bad news that impacts that asset class or those securities.
Additionally, diversification may help smooth out returns in volatile times since different asset classes tend to react differently to economic and market events. That may lead to higher returns over longer time periods, and it may help investors avoid the pitfalls of emotionally-based investment decisions.
Let’s look at concentration risk first.
Reduce concentration risk
U.S. large-cap shares[1] have experienced a remarkable run-up in value since the 2008 financial crisis. Their outperformance was facilitated by fiscal stimulus, record low interest rates, and strong corporate earnings. Following the onset of the Covid pandemic, tech-focused companies, led by giants like Amazon, Apple, and Microsoft, became the dominant force in driving the market’s overall gains. Investors who had large allocations to these companies were handsomely rewarded.
But tech shares didn’t do so well in 2022 and portfolios that were heavily weighted in those names would have felt that downturn far more than portfolios that had a healthy mix of large-cap, small-cap, and local and international shares, as well as bonds.
Employing a diversified investment strategy can help investors create a balanced portfolio that avoids overconcentration in any given asset class.
Historical data show that there is no single asset class that you can bank on always to get you the best return, and there’s no way to predict at the start of the year how the next 12 months will unfold. Since we know consistently picking the best performing asset class is not a realistic strategy, the next best option is to diversify your holdings to avoid over-concentration in a single asset class, never miss out on the year’s leading asset class, and potentially smooth out returns over time.
Overcoming home country bias
Many investors, knowingly or unknowingly, tend to over-concentrate their portfolios in the regions or companies with which they are most familiar. Their thought pattern may run along these lines: “I know plenty more about the economic conditions and current market environment of my home country because I am actively participating in both.” Investing in this way is a tendency known as “home country bias” and can be a roadblock to having a fully diversified portfolio.
Sources: Sources for the asset classes and sample multi-asset portfolios are as follows: NZ Shares: Russell NZ Domestic Gross Index (Replaced with S&P/NZX 50 Gross with Imputation TR from June 2016). NZ Cash: S&P/NZX 90-day Bank Bill Index. NZ Bonds: S&P/NZX NZ Government Bond Index. Global Bonds: Bloomberg Global Aggregate Total Return Index Hedged NZD Global Share: MSCI World NZ$ Hedged. The diversified portfolios are hypothetical only and are calculated by a weighted average of the asset class index returns shown using sample asset allocations. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
As you can see, markets change, and all asset classes cycle in and out of peak performance.
The next decade could look the same as this one, the current one, or end up wildly different, since past results are no guarantee of future performance. And since we don’t know what the future holds, owning a diversified mix of asset classes can help ensure your portfolio always has a portion dedicated to each year’s top performer, no matter where we are in the market cycle.
May help smooth out returns in volatile times
A properly diversified portfolio is comprised of investments whose returns do not move perfectly in the same direction, or with the same magnitude. The idea behind this approach is to help smooth out portfolio returns. While multi-asset portfolios never take the top place each year (nor the bottom place), they are consistent in delivering steady returns over a prolonged timeframe. It is important for investors to maximise potential returns per unit of risk taken. In this context, we identify risk as standard deviation – the more volatile and uncertain the return outcome the higher its standard deviation. All else being equal, investors would choose a lower volatility portfolio over one with higher volatility offering the same return.
Source: Russell Investments Capital Market Forecasts December 2024. Muti-asset portfolio taken as 10% NZ Fixed Interest, 30% Global Fixed Interest, 40% Global Equities (50-50 hedging Ratio), 15% NZ Equities and 5% NZ Cash.
Global Bonds |
Multi-Asset Portfolio |
Global Equities |
|
|---|---|---|---|
|
Expected return |
4.8% |
6.5% |
7.7% |
|
Risk (standard deviation) |
6.3% |
7.5% |
13.2% |
|
Expected return per unit of risk |
0.76 |
0.87 |
0.58 |
|
Frequency of negative annual return |
1 in every 4.4 years |
1 in every 5.2 years |
1 in every 3.4 years |
Our sample portfolios above show some portfolios (namely Global Bonds) offering lower returns and lower risk, and some portfolios (namely Global Equity) offering higher returns and higher risk. However, and importantly, they offer quite different return per unit of risk, with the asset classes also behaving differently in various market conditions. By combining asset classes with different return characteristics, we can create a portfolio with a blended return and one which is more resilient to a variety of market conditions, i.e. it will exhibit lower risk in the form of a lower standard deviation in its return. Our multi-asset portfolio should, therefore, deliver better returns per unit of risk (known as the Sharpe Ratio) than any given asset class on its own.
Slow and steady wins the race
Chasing last year’s winners has not proven to be a reliable strategy to increase wealth. Let’s take a look at how a diversified portfolio comprised of a variety of equities and investment grade bonds performed compared to picking last year’s best performing asset class.
Sources: Muti-asset portfolio taken as 5% NZ Cash, 15% NZ Fixed Interest, 30% Global Fixed Interest, 40% Global Equities, 10% NZ Equities. Represented respectively by indices S&P/NZX 90-day Bank Bill Index, S&P/NZX NZ Government Bond Index, Bloomberg Global Aggregate Total Return Index Hedged NZD, MSCI World NZ$ Hedged, S&P/NZX 50 with Imputation TR NZD. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
Smoother returns should help investors sleep better at night. And it may help them avoid pitfalls of emotionally-based investment decisions. Sometimes investors panic when they see their portfolios fall in value, and move into cash to avoid further losses. But doing so locks in the loss in portfolio value and means they then have to look for the best point of re-entry. Without a crystal ball, however, they may end up buying back in at the wrong time and miss some or all the market’s rebound. This is contrary to the principle of successful investing: buy low and sell high.
The bottom line
Diversification is a tool to help mitigate risk in a portfolio so you can navigate all market environments while keeping focused on a long-term goal. U.S. large-cap shares may continue to lead the markets in the next few years – or they may not. History has shown us that market leadership eventually changes. No one can predict when that change will occur, nor which asset class will emerge as the leader. The best we can do is prepare for all potential outcomes with a diversified portfolio.
[1] Shares in publicly-traded companies with a market capitalisation of $10 billion or more.
The information contained in this publication was prepared by Russell Investment Group Limited (RIG). RIG is the investment manager for UniSaver. This publication has been compiled from sources considered to be reliable, but is not guaranteed. This publication provides general information only and should not be relied upon in making an investment decision. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation and needs. All investments are subject to risks. Past performance is not a reliable indicator of future performance.
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