Diversification within investment portfolios is an effective way of maximizing return within a specified degree of risk (a ‘risk budget’). Risk can be measured using an estimate of total portfolio volatility.
For example, a low target volatility portfolio would typically consist of a higher share of bonds (both government and corporate) versus equities. Implicit in this construct is the opportunity to apply ‘tilts’ to the weightings. If a positive short-term outlook on equities is held, the portfolio allocation can be increased above the longer-term strategic weight (an ‘overweight’ position). This is typically done on a valuation basis in order to increase the portfolio’s exposure to relatively ‘cheap assets’ which benefit from higher implied sustainable returns 1. Crucially, these tilts are applied within the constraints of the volatility tolerance level determined by a client’s risk profile.
While in principle diversification is straightforward, its benefits rely on the assumption that different asset classes do not behave in a uniform manner. Therefore, losses in one asset class may be offset by gains in another (whilst the same logic can also be applied within asset classes), smoothing the overall investment experience for the diversified investor.
We can use a simple example to illustrate this. First, we can consider the returns that you would receive with an entire allocation to either cash, equities or bonds in the period 1920-2015 (Figure 2). While equities saw a much higher annualised return, this comes at the cost of significant volatility, with 25 out of 96 years ending with negative returns. Meanwhile, although bonds have seen around a third of the volatility and fewer years with negative returns, the annualised returns were significantly lower. However, the construction of a simple portfolio composed of 50 per cent equities and 50 per cent bonds has a better risk-adjusted performance, represented by a higher ‘Sharpe ratio’. This is a simple measure of how well the return of an asset compensates the investor for the risk taken (also known as a ‘risk-adjusted’ return).
Figure 2: Portfolio returns under different asset class mixes (1920-2015)
Source: HSBC Global Asset Management, as of 28/12/016
Meanwhile, although the high return on equities versus safety asset classes is attractive over the long run, the bumpy journey results in periods of significant cumulated losses or ‘drawdowns’ (Figure 3). A balanced portfolio can also help reduce these losses over the investment horizon, enabling investors to ‘stay in the market’ and reap the longer-term reward.
Figure 3: Cumulated losses under different portfolio mixes
Source: HSBC Global Asset Management, as of 28/12/2016
1 Indeed, it can be shown that over a long-term horizon (eg 10-20 years) a relatively low starting valuation correlates with a positive inflation adjusted return. This applies across almost all of the investment universe.