The importance of diversification
Investment markets experienced extraordinary turbulence in 2020. In April, oil prices became negative for the first time in history. Meanwhile, the share price of online retailer giant, Amazon, climbed more than 500% over the past half-decade. Despite tremendous challenges, strategic investors have lucrative opportunities. And diversification underpins nearly all successful investment strategies and sets the most successful investors apart.
In an insightful recent webinar, Petiole Asset Management AG CEO, Hani Abuali, and CIO, Naji Nehme,discussed the importance of strategic diversification with leading advisor and author, David Martin Darst,CFA. They shared expert insights about how investors can avoid traps and benefit from enhanced diversification.
What is diversification?
“Diversification is an investment approach,” Darst explains, “It seeks to reduce portfolio risk and to enhance our augment investment returns by how allocating investments among different kinds of financial instruments.” Returns from more than one source of revenue are the cornerstone of good diversification. It helps avoid heavy losses while stabilising portfolio performance.
Diversification is at the heart of the modern portfolio theory pioneered by Nobel prize winner Harry Markowitz, who found that a mix of assets categories can enhance returns while mitigating risk.
How diversification enhances returns
“[Diversification] seeks to improve portfolio performance by investing in different instruments, asset classes, and even different geographical regions,” comments Darst. “To gain exposure to different parts of the investment universe that will react differently to changes in fundamentals.”
Investment managers increase diversification to find more sources of alpha. For example, investors who put all their wealth into the Saudi Stock Exchange (Tadawul) over the past five years, would expect returns of around 5.5%. This is not a bad return. The underlying portfolio can be diversified across various sectors, but exposure is still concentrated in one economy, one currency and one commodity (oil).
Had these investors invested half their wealth into an international exchange traded fund (ETF) (tracking the Dow Jones Industrial Average index), their returns would have been around 6.5%.
Had these investors put one third of their money into illiquid markets, their returns would have been significantly higher at around 9%.
This shows how more sources of revenue increase returns. In this example, returns would have nearly doubled over 10 years.
Nehme added, “But the real question is ‘what happened to the risk?’” The magic of diversification, when done correctly, is that it offers more returns, while decreasing overall risk.
How diversification reduces risk
Enhanced returns usually come with increased risk. The risk-return trade-off is a well-known economic rule. However, with expert diversification, risk can be reduced while increasing the potential for returns.
“The benefit of diversification,” explains Nehme, “[is] to optimize your return relative to the risk.”
The next graph adds risk (shown in red) to the returns in the previous example. The risk of investing in just Tadawul was around 8% with a return of 5.5%. When the investment portfolio was diversified across Tadawul, public and private markets, the risk was halved to 4% and returns almost doubled to around 9%.
Investing in just one asset, currency or commodity increases risk, while investing in a mix of assets mitigates it. Diversification is the investment equivalent of the proverb, “Don’t put all your eggs in one basket,” spreading the risk across market sectors. Some stocks might sink, but others will rise. Balanced portfolios which incorporate high-quality assets from different market sectors, geographies and income streams, are less exposed to market sector shocks, and therefore have lower risk with potentially higher returns.
Diversification is especially important in a crisis
Darst comments, “Mike Tyson, the famous boxer, he said, ‘Everybody has a plan until they get punched in the face,’ and when the market is punching you in the face, you need a plan. The people who had diversified portfolios—truly diversified—and a plan, did not miss out on one of the most powerful rallies in history, when asset prices rebounded 70% or more… certain indices have doubled or tripled from their lows.” Investors who were diversified stood by their investment strategy because they recovered losses from gains in other assets. As a result, they can profit during the recession.
Investors who diversified with illiquid and private market investments have benefitted especially. “Of course, [private markets] are not as fast-moving as public markets,” elaborates Abuali. “So, you’re not seeing as much of that volatility, but what you are seeing is this concept of investing in companies that benefit from COVID—think about it on other forms of private diversification… There are trends we’re very conscious of, so if you have significant exposure to [for example] multi-family, office, warehouse, logistics and other forms of real estate, then you’re able to weather the storm.”
How investors diversify their portfolio
A diverse range of assets means different things to different people. Capturing a mix of different asset classes, market sectors and geographies is a good start.
Investment managers focus on how assets react to volatility. “The way we think about diversification and the way we practice more importantly is we think about uncorrelated returns to markets,” elaborates Abuali.
What are the asset categories to consider?
Investments derive their value from a range of factors broadly split into three groups:
Capital assets includes stocks, bonds and properties in the public and private markets that are held and traded for investment purposes. Their value is determined by the ebbs and flows of the market.
Supply-and-demand assets include mostly commodities, such as oil or gas. Their value is affected by geo-political events and regulations (e.g., the upcoming carbon-neutral initiatives in the European Union).
Store-of-value assets include classic cars, art, gold or jewellery. Their value is determined by what buyers are willing to pay for them.
Investors should include more than one of these categories in their portfolios to diversify. If all the investments derive their value from the same source, they are not well diversified.
“A lot of people think of their diversification as numbers,” Nehme expands. “And it’s not about numbers, it’s about having assets behave differently.”
Is there a standard rule for diversification?
No two investors are the same, and different levels of diversification are required for different investors. Those who need to access their wealth within the next 10 years cannot invest in illiquid assets, such as the private markets. Others may have a shorter investment horizon. The correct proportion of assets depends on the life stage and goals of the investor. “It is not a science. It's as much about what are your investment characteristics as a person, which stage of the life cycle you are,” Nehme comments.
Before building a diversified portfolio, investors should reflect upon their unique:
Capital and liquidity needs,
Attitude to risk, and
“I want to emphasize the idea of security. In this age it’s very, very important that your assets be cyber-secure,” highlights Darst.
Traps investors should avoid
Diversification is a highly strategic process. When done correctly, the potential for returns increases significantly while lowering risk. When done incorrectly, it can lead to a false sense of security.
Be wary of investing in the same companies several times. Major ETFs main contain the same companies, offering very little diversification from each other. Investing in several ETFs does not achieve diversification.
Avoid home bias. Most investors favor local investments for three reasons:
Advantage of access to local information, and
Complexity of foreign taxes and laws.
In conclusion, diversifying assets internationally leads to better results. By working with a family office, you can get local access and experts to exclusive private investments. The Family Office and Petiole Asset Management have “boots on the ground” in many regions globally, who source the most promising private investments.
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