Last year highlighted how events can completely confound investors’ expectations and that (excuse the pun) 20/20 vision exists only in hindsight. Attempting to anticipate the future does have merit, of course, and there are certain risks like inflation the whole investment community is on high alert for. But really, all we can say is that investors will face both headwinds and tailwinds in 2021, hope that the latter exceed the former, and strap in as securely as we can to face both.
What does this mean in practice? Diversification – a precept of sound portfolio construction so paramount and basic that it almost goes without saying. Except that it does warrant revisiting again and again as we regularly review our investments, and most definitely at specific danger points.
The trouble is that the principle of “not putting all your eggs in one basket” is easily grasped, but trickier to put into practice properly. We know we should be reducing risk exposure by investing across asset classes, regions, sectors and currencies, but it is only too easy to think superficially rather than really dig in.
Let’s take the appropriate asset class split: historically, the average investor’s starting point might have been to allocate 60% of their portfolio to equities and then balance these risk assets out with a staid but steady 40% allocation to bonds. This split has always served investors well and even did through the pandemic when the two assets classes showed they can indeed tumble together.
A need for nuance
Although the general principle of not going completely “risk on” holds, experts are now advocating a more nuanced approach. Low bond yields and the potential for corrosive inflationary effects mean the risk-return profile of the traditional 60/40 portfolio could rapidly deteriorate. To meet their return objectives, investors are then likely to need a more tailored - and broad-minded - approach.
To enhance both returns and diversification, the super wealthy have been increasing their allocations to alternative investments for many years. But an idea which continues to gain currency is that even relatively modest investors should trim both the equities and bonds proportions of their portfolios in favour of alternatives too. An appreciation of the potential downsides means non-traditional assets might be appropriate for only a small proportion of a portfolio, but a more tailored and adventurous approach might be what diversification should now mean to you.
Needless to say, the alternatives category is both broad and esoteric, covering everything from commodities, property and private equity through to collectibles and cryptocurrencies. And, if you are only allocating, say, 10% of your portfolio to alternatives, it is crucial you choose the right one(s). Savviness about diversification might dictate the instruments you use to execute that view too, leading you, for instance, to buy a basket of cryptocurrencies through a fund rather than a Bitcoin or two.
Danger in complacency
The point is that investors need to be looking at diversification at both a broad brush and more granular level, spreading risk among asset classes, but also within them.
As is well known, equity investors commonly exhibit a home bias that both increases risk and negates the returns potential of looking further afield. Furthermore, many national stock markets themselves now show potentially dangerous sectoral skews, partly because the number of companies listed on them has halved since their 90s peaks.
When buying indices (and indeed anything else) investors need to look under the bonnet to really understand what they will own – and how this intersects with the entirety of their other holdings. Ask yourself, is it possible I am replicating risks again and again?
Ensuring proper diversification is, in short, a fiendishly complex task (not to mention a never-ending one). It absolutely must be tackled though, in-depth and without delay.
There has always been great danger in complacency and many times more so now. When it comes to carefully diversifying your portfolio, I urge you, don’t be caught out.