While it’s commonplace for investors to hold multiple investments in a portfolio — often comprised of mutual funds or ETFs that in turn hold dozens or even hundreds of underlying positions — even multi-asset-class portfolios aren’t always really diversified.
Holding many different investments aligned to the same base case market scenario, and that all go up or down together, may be equally risky.
For instance, a so-called well-diversified portfolio holding stocks from the U.S. and emerging markets, plus commodities and corporate bonds, may be invested into multiple asset classes but would all be expected to go up in a growth environment. Conversely, they all would likely decline severely in a recession.
Of course, investments that don’t go down in a recession, from defensive stocks to government bonds, are also the investments likely to perform the worst when markets rise. But in the end, that’s the whole point of diversification: to own investments that will defend in the risky events, even if it means sacrificing some upside. Viewed another way, being well diversified means always having to say you’re sorry about some investment that’s not moving in the same direction as the rest.
Given the complexity of today’s investment environment and the typical multi-asset-class portfolio, a growing range of tools are becoming available to stress-test various risky scenarios, to help determine whether a portfolio is truly diversified, or just holds a large number of investments that are all expected to go up — and down — in an undiversified manner.
Origins of portfolio diversification
The concept of diversification traces back thousands of years. In Judaism, the Talmud illustrates the principle by stating, “it is advisable for one that he shall divide his money in three parts, one of which he shall invest in real estate, one of which in business, and the third part to remain always in his hands” (Tract Baba Metzia). The Bible, meanwhile, recognizes the importance of diversification even more directly: “But divide your investments amongst many places, for you do not know what risks might lie ahead.” (Ecclesiastes 11:2).
In a modern context, the Bible’s unknown risks are further divided into two subcategories: idiosyncratic risk that is specific to a particular investment (also known as unsystematic risk), and market risk that an investor takes on simply by investing in the markets (also known as systematic risk). The distinction is important because research has shown that by owning a sufficient number of individual stocks, an adviser can diversify away the specific company risk of any particular stock in the portfolio. However, because all the stocks are still tethered to (and in fact comprise) the stock market, the adviser cannot fully diversify away the aggregate risk of the market itself.
Of course, it’s still possible to diversify out of the stock market, which was what the Talmud prescribed by indicating that only one-third of assets should be invested into businesses, with another third in real estate — an entirely different asset class — and the last third “in [your client’s] hands,” e.g., in cash. More generally, this means that the next layer of diversification is to spread assets across entire asset classes, ideally ones that are so different from each other that the idiosyncratic risks of one asset class in the aggregate are still not shared by the others.
In other words, broader and broader diversification is simply about spreading investments out to minimize exposure to any one of a broader and broader range of potential risks.
Diversification means always having to say you’re sorry
The point of diversification is to spread out a client’s exposure to various risks, such that if the risky event occurs, not all investments are adversely impacted. But an important corollary of diversification therefore applies as well: If the risky event does not occur, not all the investments will benefit.
Imagine a portfolio invested on the base case that the economy is healthy and will keep growing. Such a portfolio would have a healthy allocation to equities along with exposure to commodities, and would likely tilt toward more volatile higher beta stocks (e.g., small cap and emerging markets). A strong economy also tends to keep the default rate low, so an adviser would likely also favor corporate bonds over government bonds (and ideally, high-yield bonds with the greatest return boost in a low-default environment). Any interest rate sensitivity (i.e., duration) would be kept low, as a strong economy is likely to eventually face rising interest rates.
The fundamental problem with such a portfolio, however, is that while it’s spread out across a number of different asset classes, it is very poorly diversified. The portfolio actually just owns multiple asset classes all aligned toward the same risk: benefitting as long as the economy grows, and vulnerable if a recession occurs.
If we approach from the risk side of the spectrum, what happens if the base case for economic growth is wrong and a recession does occur? Markets will decline, with the most volatile high bet” stocks falling the most. Default rates will rise, leading to widening spreads that hammer the price of high-yield corporate bonds. And if the Fed responds by trying to cut interest rates — or more generally, interest rates decline in anticipation of the lower real return environment — the portfolio’s low duration will not provide much benefit, either.
If your client truly wants to be well diversified, it’s necessary to own investments that will perform well in the risky scenario (i.e., the recession), even if it means that those investments will perform poorly and not work out well when markets are on an upswing. For instance, the portfolio would eliminate some of the high-beta stocks, opting instead for defensive stocks, and would carve out some of the high-yield and low-duration bonds to own long-term government bonds.
If the recession scenario occurs, the more defensive stocks, along with the government bonds, will perform well. Of course, if the growth scenario continues to play out, those same allocations will be the worst performers in the portfolio. But that’s actually the point: If the portfolio is well diversified against the risk of a recession, it will also be diversified enough to not perform as well if the risk doesn’t occur.
Viewed another way, being truly well diversified means always having to say you’re sorry about some investment that’s not moving in line with the rest of the portfolio, to the upside or the downside.
Optimal diversification in bull markets
There’s a notable caveat to the principle of diversification. By owning investments that will go up when other assets go down, the portfolio doesn’t necessarily come out ahead. For instance, an adviser could simply put the client in an inverse ETF fund — or in the extreme, a leveraged 2X or 3X inverse fund — and it would be assured of going up when the market goes down. But given that the market goes up more than it goes down, such positions would really just drag down the long-term return of the portfolio. Diversification should never be an excuse to own an outright inferior investment with no long-term return potential.
Ideally, then, the goal is to either find an investment that still has reasonable long-term returns but an outright low correlation, or — even more ideal — an investment that has a correlation that is positive in up markets but a lower correlation (i.e., is a better diversifier) when markets are down.
A case-in-point example is a comparison between corporate bonds versus government bonds in a portfolio. Both have fairly low correlations to the market overall; the rolling 12-month correlation between the S&P 500 and long-term corporate bonds is only 0.22, and the correlation between the markets and long-term government bonds is just 0.09. In this context, government bonds would be viewed as a slightly better diversifier than corporate bonds, given the low correlation, but this superior diversification comes at the expense of long-term returns. The average annual compound growth rate of long-term corporate bonds is about 6%, compared to just 5.6% for long-term government bonds.
However, the long-term correlation and returns of these investments are somewhat misleading, because they are not consistent throughout the economic cycle.
For instance, among all the historical rolling 12-month periods where the return on the S&P 500 is positive based on Ibbotson monthly data, the average return of corporate bonds is a whopping 7%, and government bonds trail even more with a return of only 6.2%. In these environments, the correlation of corporate bonds is 0.19, while that of government bonds is 0.08.
However, in the historical rolling 12-month periods where the return on the S&P 500 is negative, the average return of corporate bonds falls to just 4.7%, while government bonds have a superior return of 5%. In the process, the correlation of corporate bonds holds fairly stable at 0.18, while the correlation of government bonds to the S&P 500 falls straight to 0.0.
In other words, it may appear that government bonds have a slightly lower return, as compared to corporate bonds, in exchange for providing a lower correlation to the S&P 500. But as a diversifier, government bonds are drastically better, because they underperform corporate bonds when stocks are already up, but outperform corporate bonds when stocks are down and it matters the most. Viewed another way, the government bonds are the better buffer against bear market declines, and the lower return in a bull market is simply the price to pay — a price that shouldn’t really matter because stocks are already bringing huge returns to your client.
Stress-testing the risks
One significant challenge to crafting a well-diversified multi-asset-class portfolio is that not all risks impact all asset classes the same way. After all, the fact that certain investments may respond differently to a similar risky event is what defines them as different asset classes.
Consider the case of inflation. Both stocks and commodities react well to modest inflation, but significant inflation may be especially good for commodities while bad for stocks, in part because the more expensive commodities cause higher input costs that drive stock prices down. Similarly, modest inflation may allow government bonds to perform well, but significant inflation forces interest rate increases that adversely affect interest rate–sensitive bonds. On the other hand, corporate bonds may perform especially well in a rising inflationary environment, as companies eventually pass through price increases that lift their nominal earnings and make their debt easier to service (even if real earnings are not rising).
Different asset-class dynamics can also apply to deflation (and may vary depending on the cause of deflation), growth vs. recession environments, rising vs. falling interest rates, or even times of peace vs. times of geopolitical unrest.
The added complexity to advising in this manner, as noted earlier, is that not only do different asset classes react differently to external events, but their reactions are not always symmetrical. Deflation is worse for commodities than inflation is good for them. Modest inflation is good for stocks, but severe inflation can be disastrous. Government bonds underperform corporate bonds in growth environments, but outperform them in the recessions when they’re needed most for diversification.
These dynamics mean that in practice, it’s not enough to simply look at basic portfolio statistics such as long-term average correlations. Instead, portfolios must be evaluated for their exposure to specific risks, with recognition of how the portfolio might respond to those particular risks. Advisers should ensure that there is a healthy level of diversification to a wide range of possible outcomes.
Fortunately, a growing number of tools are becoming available specifically to analyze and stress test such scenarios. Companies like Hidden Levers, RiXtrema and MacroRisk Analytics all provide solutions for advisers to input portfolio allocations, and evaluate how the portfolio might respond to scenarios — from an inflation shock to a further oil crash, or from inflation picking up or rolling in a deflationary direction.
The purpose of all these tools, of course, is to identify scenarios where a portfolio is too disposed toward a single outcome, and thus overexposed to the potential for harm.
As with all of these uncertainties, there is still some base-case scenario that is most likely to play out. Inflation is more likely than deflation, peace is more likely than world-engulfing geopolitical unrest, and even though recessions may be inevitable, growth is still more likely to occur from year to year, all else being equal. Still, the point of diversification remains the same: Even if the expectation is for growth, modest inflation and peace, there’s still a risk of recession, deflation or geopolitical crisis. This means that the portfolio should hold some investments that will perform well in these scenarios, even at the risk of underperforming if everything else works out as planned.
So what do you think? How do you evaluate whether a portfolio is really diversified? Do you segment the portfolio into its diversification in bull versus bear markets? Have you ever tried portfolio stress-testing? Please share your thoughts in our comments section.