One of the most important decisions to make when constructing a sensible investment portfolio is to achieve the correct balance between risk and reward, which is appropriate paying regard to the risk tolerance of the investor. Naturally, investors are always keen to maximise returns where possible and they may be tempted to build a portfolio that aims to seek growth in areas that are outperforming at the time. The downside of such an approach is that this often carries additional investment risk.
An effective way of reducing portfolio risk, is to add diverse types of investments and blend them together, thus creating a diversified investment portfolio. Mathematical studies to determine the optimal diversified portfolio started over 70 years ago, with the most notable study being Harry Markowitz’ Modern Portfolio Theory in 1952, for which Markowitz won a Nobel prize. Modern Portfolio Theory first determined the most efficient way of holding assets that are either positively or negatively correlated, and introduced the notion of the Efficient Frontier, which aims to produce a set of investment portfolios that are expected to produce the highest return at a given level of risk.
Portfolio Diversification in action
The simplest form of diversification is to select investments across different asset classes, such as equities, bonds, property, commodities, and cash. Additional diversification can be achieved by investing in different regions of the world, where the growth outlook may differ.
Balancing exposure between different sectors and industries, such as technology, industrials, consumer products, energy, and finance can add further diversification. Within equity markets, stocks that offer a value bias, with a strong dividend yield and good cashflow, can be blended with more growth orientated, or smaller companies, with better prospects for growth, but at the cost of additional risk.
Practical benefits of diversification
Constructing a diversified portfolio can help reduce the overall level of risk within an investment strategy, as a diversified portfolio is less exposed to a downturn in the fortunes of a single company, industry, or country. It can also help stabilise returns, as different assets behave differently at each point of the economic cycle. For example, in a period when equity markets fall, other assets, such as fixed interest securities, may be less affected, and reduce or limit the drawdown on the portfolio value.
A diversified portfolio can also help cushion the blow if an unforeseen event occurs. A good example of this is to consider the stabilising effect of investment grade bonds and alternative assets during the initial stages of the Covid-19 pandemic.
Diversification in today’s markets
It is abundantly clear that investment markets today bear little resemblance to the stock market at the time Markowitz created the Modern Portfolio Theory. Whilst the general principle of portfolio diversification holds true today, investors need to consider whether the ever-changing investment landscape calls for portfolios to be adjusted more frequently to match shifting market trends.
Firstly, Modern Portfolio Theory assumes that investors take rational investment decisions. Increasingly we are seeing global markets driven by sentiment, with the “herd” mentality of investors focusing on a particular sector, industry, or idea. In part, passive investment funds, which track a particular index, are driving this trend. As funds are allocated in accordance with the weight a company holds in the index, more money is allocated to the largest stocks by weight, further boosting that company’s position in the index, which has a greater bearing on future index returns.
A second key point to consider is that assets that are usually uncorrelated can move in line with each other at different points in the investment cycle. For example, the Great Financial Crisis of 2007-8 had a negative impact on all asset classes, from equities to bonds to property. We have also noticed that equities and bonds are more closely correlated in periods of higher inflation. For example, shortly after the Russian invasion of Ukraine in 2022, global inflation pushed sharply higher, and UK inflation peaked at 11.1%. As a result, most asset classes struggled during 2022, with both global equities and global bond markets falling during that year.
Finally, the pace of change in investment markets is accelerating, with new investment trends becoming mainstream more quickly than has historically been the case, due to the speed at which investors can access information. This is likely to lead to greater market distortion over time.
The importance of portfolio reviews
In today’s rapidly changing world, investment portfolios need to be able to adapt. Whilst portfolio diversification remains a tried and tested building block of any sound investment strategy, keeping a portfolio under review, to ensure the level of risk remains appropriate, is even more crucial than ever.
We often see investment portfolios and strategies that have not been properly reviewed. Frequently, the investor is unaware of additional risk due to the change in asset allocation from the original portfolio design. It is also common to see portfolios that are heavily focused on one geographic area – often the UK – and carry lower levels of exposure to global markets, which can lead to excessive risk.
You can help keep investment risk in check by regularly reviewing a portfolio and making changes where appropriate. At FAS, our ongoing advice service offers a comprehensive and robust review at regular intervals, and part of this review looks to ensure that investment portfolios remain adequately diversified. We may also recommend a rebalancing exercise, which adjusts portfolio asset allocations to maintain a preferred balance of risk and reward.
If you hold an investment portfolio that has not been reviewed recently, then speak to one of our experienced advisers. We can assess existing investment portfolios and provide tailored solutions on an advisory or discretionary basis, using our research and analysis of investment funds from across the marketplace.
