As recently as a couple of weeks ago, recession fears have fuelled market volatility and uncertainty, leaving investors faced with the stark reality of the volatility inherent in their portfolios.
Diversification is the easiest way to smooth volatility in a portfolio and therefore it has been brought sharply to the forefront of investors’ minds. Now is the perfect time to assess both the make-up of your portfolio and risk exposure within the portfolio.
Background
Simply put, the aim of diversification is to avoid putting all your eggs in the same basket. In the case of investing, it means optimising the mix of assets in a portfolio to minimise risk and maximise returns.
Government bonds, investment grade (IG) bonds, high yield (HY) bonds, shares, hybrids, property, commodities and cash are all examples of different asset classes. Each of these assets has a varying degree of volatility, which means their price movement (the quantum and direction) in reaction to an event is different.
Whilst the general directional movement of these asset classes is generally similar, it’s the quantum of their respective price falls and hence volatility that varies quite significantly. It’s also worth noting that with central banks uncertain over cash rate trajectories and concerns over possible recessions, each asset class will be tested, but some will be impacted more than others. Here we discuss why diversification is key to protecting portfolios.
Diversification in practice
Many investors would be familiar with the concept of an efficient frontier, which shows the relationship between incremental risk and return. Below is an illustration of this relationship.
Investing in a 100% equity portfolio offers historical high returns but also has high risk associated with it. This risk reduces as you start to add bonds to this portfolio, and this incremental reduction in risk outweighs the reduction in return.
According to the 2021 OECD data most countries have a greater preference for bonds over equities in pension portfolios, with Australia being one of the exceptions, as illustrated in the chart below. It shows Australia with a greater allocation to equities (41.8% of overall allocation) than bond investments (14.7% of overall allocation) in pension funds.
For years we have been advocating the inclusion of various asset classes in investment portfolios. The risk of investing primarily in one asset class such as shares for capital gains, high dividend income and the associated franking credits is again in the spotlight as numerous companies, including banks, reassess their earnings outlook and dividend policies.
Dividends are discretionary, unlike coupons paid on bonds. Investors learnt this the hard way during COVID when APRA forbade the banks from paying a dividend, which has not been made up.
Similarly, investing exclusively in high yield bonds for their higher coupons may also not be appropriate given the risk associated with these issuers.
Diversification is vital within a single asset class as well, such as a bond portfolio. This can be achieved by holding a mix of bonds across the various categories highlighted in the table below. This list is by no means exhaustive, there are also other factors such as maturity profile that should be considered when building a portfolio.
Current opportunities
The ongoing market uncertainty, allied to geopolitical risk having risen with the US election, Ukraine war and Middle East tensions have again highlighted the importance of diversification.
Diversification across asset classes is a key consideration for all investors to understand and implement for their own protection. Equally, diversification within a single asset class is also an essential element of protecting investment returns.
Price moves and dislocation across asset classes during this time due to volatility provides an ideal opportunity to assess portfolios and make adjustments at both an asset class and individual investment level.
Please contact FIIG Securities to further discuss how a well-diversified portfolio with a healthy inclusion of corporate bonds can help you.