Diversifying a trading portfolio to minimise risk when markets are in turmoil has proved more essential than ever during the current coronavirus pandemic.
Although diversification does not guarantee better returns or fewer losses, a broad spread of investments across different stocks, bonds and other asset classes will normally result in better, steadier returns than if you decide to keep all your investment eggs in one basket.
Diversifying minimises risk, steadies returns
All markets go up and down, and sometimes they go down much faster than anybody expected. If you were to put all your money into the stock market, the losses can be catastrophic if the market crashes. The same is true if the money is all tied up in real estate, or forex, or any other single investment.
But markets rarely crash at the same time and to the same degree. If stock markets are falling, bond and gold prices are likely to be headed in the opposite direction, for example. It therefore makes sense to spread investments across different sectors to hedge against any sudden downward swing in equity prices.
Even when many different asset classes do fall at the same time, which happened during the 2008-09 bear market and in March this year at the height of the coronavirus panic, diversification can help to mitigate overall losses.
Individual investors will often chase higher-risk investments during bull markets and run to lower-risk options when markets reverse course, resulting in larger losses during bear markets.
For this reason, it is better to plan a long-term investment strategy that spreads risk across different asset classes so that the overall level of risk is something you are comfortable with, and to revise and rebalance your portfolio as circumstances change.
Goals, risk tolerance, strategy
Before assembling a diversified portfolio, you should typically consider what your investment goals are and over what timeframe – whether, for example, the investment is for a short-term purpose or something longer-term such as pension planning.
This will make a difference to your mix. Bonds are less volatile than shares, for example, but shares tend to outperform over a period of years. For this reason as well, a longer-term plan will be able to absorb greater risk. If, however, you have an aversion to risk, a smaller proportion of stocks would be a more suitable choice.
The role of correlation in a portfolio is another consideration. As mentioned, stocks and bonds have a reverse correlation with each other in that under normal conditions when one rises, the other falls. Stocks also have a reverse correlation with gold, a traditional safe haven asset to which investors often turn during a bear stock market. There are also correlations and reverse correlations within asset classes to consider.
Having determined the eventual goals of an investment portfolio and the appropriate level of risk, it is then time to allocate different proportions of the portfolio to different asset classes, and within that to spread the risk across different sectors and geographies.
Diversifying stocks by sector, size and region
Having decided the proportion of stocks against other assets in your portfolio, the next step is to diversify within this mix. This involves deciding how much of a share portfolio should be domestic and how much foreign. For shares of overseas companies, you will need to decide how these should these be divided between lower-risk developed countries and higher-risk emerging markets.
Shareholdings can also be spread across different sectors, with a portion in potentially high-return technology shares, for example, offset by a relatively risk-free tranche in ‘defensive’ sectors such as consumer staples, which provide basic necessities whatever the economic situation. Other details you should consider when assessing various risk permutations include blue-chip companies with a long history of profitability versus fast-growing but smaller companies and new listings.
Care needs to be taken to ensure there are not too many investments in one area of a market and no undetected duplications, which could happen if, say, one company appears both in a blue-chip category and in a developed markets category.
You also need to not overplay the importance of recent past performances of shares and sectors. Shares that have done well over the past year might not be so strong over a longer timeframe. Correlation, reverse correlation and an absence of correlation should also be considered between individual stocks and sectors.
Another means of hedging risk between shareholdings is to diversify by geography. Although investors are naturally biased towards their domestic markets because they know them better, this risks leaving all the equity eggs in one geographic basket, so it pays to spread the risk by looking to overseas markets.
There may not be a direct correlation between one geographic area and another. So a poor performance on the Japanese stock market, for example, could be hedged by a solid showing on the Australian market. In other regions, however, there may be a degree of correlation. The impact on global trade of the COVID-19 crisis has weighed heavily on all export-dependent and emerging market economies in 2020.
Developed markets such as the United States, United Kingdom and Japan are also normally less volatile than emerging markets, even the larger ones like China, Russia, Brazil and India.
Hedging against inflation
Although not as popular an investment instrument as stocks, bonds are often used in a portfolio to counteract any sudden upward or downward lurch in stock markets. Bonds are more stable than stocks and are more closely correlated with each other. When the Fed raises rates in the U.S., rises will follow in much of the rest of the world. There are many types of bonds, however, both government and corporate, and these can be divided by type of instrument, maturity, rating, country of issue and other factors.
One danger of a portfolio that is solely diversified across stocks and bonds is that when inflation erodes the value of a currency, the interest gained on the bonds will not make up for the losses on the stock market. To hedge against this eventuality, it may be worthwhile to hold some assets in a foreign currency or to exchange part of the cash component of a portfolio for other currencies.
Other hedges against inflation include focusing equity holdings on commodities such as oil, gas and minerals, or including real estate investment trusts (REITs) in a portfolio.
A diversified portfolio can also include a mix of mutual funds and exchange-traded funds (ETFs). To make sure the portfolio is truly diversified, however, you will need to look at what is inside each fund and ensure that it does not conflict with or overlap any other part of your portfolio.
Actively managed equity and bond funds, hedge funds and private assets can add complexity to any portfolio, but there needs to be a high degree of due diligence done to ensure the risk profile is as desired and high fees do not whittle away any advantages. Fees can be lessened, however, by using passive rather than active funds.
Although diversification is a popular tool for improving returns and mitigating investment risk, too much can do more harm than good. Many advisers recommend holding no more than 30 investments in a portfolio. If asset holdings are too small, the investor will benefit little if they do well. It also makes tracking each investment that much harder if there are too many to follow.
It is also important to keep track of commission costs and transactional fees, and in the case of funds, the monthly fees.
Once created, a diversified portfolio needs to be occasionally rebalanced, perhaps once a year, so that your risk profile is maintained when market conditions change.
Asset allocation funds, robo-advisers and target-date funds
If an investor does not have the time or inclination to properly diversify a portfolio, the easiest way to diversify is through an asset allocation fund. These hold a predetermined mix of stocks and other assets so that a 60/40 fund, for example, would maintain a ratio of 60 percent stocks to 40 percent bonds or cash.
Another low-cost, easy-to-use alternative for investors with a retirement account is a target-date fund, which picks a mix of investments depending on the investor’s age. As the investor gets closer to retirement, so the investment allocation becomes gradually more conservative.
But whether using a ready-made portfolio mix or going with your own, it will be essential to study the varying risks across the different allocations of a portfolio so that the overall risk is at a level you are most comfortable with. You will then need to stay up to date with market developments so you can tweak allocations to ensure the risk level stays the same.