Diversification is a frequently used word in the investment industry but it’s often taken at face value and misunderstood by investors. Common ways investors can get diversification wrong are:
Myth 1: Lots of colours on a pie chart equals diversification
Some approaches claim to be diversified because they invest in a number of different positions, usually demonstrated by showing the portfolio using a pie chart with many different colours.
In practice, however, these portfolios are often loaded with assets with common fundamental drivers, for example equities, rather than distinct assets with differing fundamental drivers. Potential diversification benefits are negated when the assets have the same fundamental return drivers. Breadth of holdings alone does not guarantee diversification. Rather, it is important to assess the underlying characteristics of assets and build a portfolio with a mix of return drivers.
Myth 2: Asset class labels accurately describe their behaviour
Market convention suggests that bonds should behave differently from equities and “alternatives” should behave differently from bonds and equities. This convention is overly simplistic – there are certain assets tagged as a bond that actually behave more like equity and certain assets tagged as alternatives that do not behave differently from either equities or bonds.
It’s therefore important to look beyond the labels of asset classes and to focus on the underlying behaviour of asset classes in determining their role within a portfolio.
Myth 3: Asset relationships are constant over time
The historical behaviour of assets relative to one another doesn’t always determine how they will behave in the future. For example, it’s assumed that government bonds are always negatively correlated to equities, or that emerging market bonds have a low correlation to equities. But asset relationships can actually vary significantly over time, and require continuous evaluation to better determine the role they can play in diversified portfolios.
Michael Spinks, Investec Asset Management