According to Harry Markowitz, the acclaimed economist who won the Nobel Prize in 1990 for his work on portfolio theory, “diversification is the only free lunch” in investing.
The Importance of a Diversified Investment Portfolio
Life is unpredictable. Anything can happen. For example, investors in China’s internet giants lost billions of dollars following extensive regulations of the technology sector in August 2021. Those who invested their entire wealth in China’s booming technology sector may never recover their losses. But those with well-diversified investment portfolios would have been unaffected. Diversification allows you to preserve your wealth across generations over the long-term through the magic of compounding, regardless of losses in any one sector.
Diversification is not achieved by just having more investments. It is achieved by investments with risk profiles that are uncorrelated to one another.
The Traditional Diversified Portfolio Model is Broken
Two key trends have upended the traditional 60/40 model portfolio (60% in public equities and 40% in bonds).
The first is the prevailing near-zero interest rates. Since 1981, bonds have been the key protection in a portfolio against steadily declining interest rates, because bonds would rise in value whenever interest rates were reduced in response to a recession.
But there is no room for interest rates to drop further when they are already near zero. Fixed income yields are at historical lows, with annual yields of investment-grade and high-yield bonds just above 1% and 3%, respectively. At such low yields, bonds can no longer protect a portfolio, and investors are not compensated for the risk of holding them.
The second trend is the growing concentration of risk in equity indices across the world after a decade of disinflation and low interest rates. Global equity indices have become heavily concentrated in:
- US technology companies
- High-yield Chinese real estate developer credit
- Chinese growth companies
- US mega-cap growth companies
In short, the indices comprising hundreds of constituent companies are no longer diversified.
The Optimal Diversified Portfolio
The modern portfolio model should invest across a wide range of asset classes that feature uncorrelated risk-reward profiles, such as alternative investments like private equity, private real estate, private credit, structured finance and selective venture capital and hedge funds.
Geographical diversification is also important in mitigating geopolitical risk. For example, the US-China trade war and the disruption of supply chains due to Covid-19 have benefited Southeast Asian countries like Vietnam, which is poised to be the next manufacturing hub in the region. The economic growth in some emerging markets is much stronger (at annual GDP growth of 6-8%) than that of the developed world.
Many indices have outperformed over the last decade due to their concentration in certain sectors amid disinflation and low interest rates. Their fortunes may reverse in the next decade amid higher inflation and interest rates.
Since 2004, The Family Office has been helping clients to preserve and grow their wealth over multiple market cycles through investment solutions tailored on their specific needs. Get in touch with us today to start your investment journey.