Spreading investments across a number of different asset classes and investment types reduces risk, or so the conventional wisdom goes. This is because so-called black swan events, when all the asset classes move in the same direction at the same time, are extremely rare – although they can and do occur.
Cian Hurley, senior investment consultant with Mercer Ireland, agrees that broad diversification is probably the best way to reduce portfolio risk without having to forgo return opportunities. “Historical events such as the collapse of Enron in 2001 have underscored the dangers of concentrated investments, especially for pension savers,” he says.
But what does diversity look like on paper? According to Hurley, a well-diversified portfolio includes a mix of asset classes such as equities, bonds, cash and alternative investments, often spread across a variety of industries, regions, indexes and currencies.
“But to further enhance diversification, we believe investors should include alternative strategies alongside the more traditional asset classes,” he says. These alternative asset classes include commodities, gold and liquid alternative funds. “These provide access to non-traditional risks and increase resilience across different market cycles.”
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In addition, many investors also incorporate some allocations to private markets in diversified portfolios, providing exposure to additional return drivers and reducing volatility further. This approach is not limited to those with large sums of money to invest; even with smaller sums, investors can achieve diversification by choosing a broad mix of assets or managed portfolios that offer exposure to multiple asset classes and regions.
“The goal is to spread risk effectively, regardless of the size of the investment,” Hurley says.
Karl Rogers, managing director and chief investment officer with wealth management service Elkstone, references Warren Buffett’s well-known comment about diversification being “the only free lunch in investment”.
“In practice, however, the execution of building and maintaining a diversified portfolio isn’t as clear or understood by most,” he admits. “I often say to clients, ‘if you’re properly diversified, someone like me is always telling you some negative performance news’; if everything is moving in the same direction, it’s not a diversified portfolio.”
From a portfolio construction perspective, Rogers says a truly diversified portfolio has within its investments multiple asset classes that behave and perform differently across a full market cycle. “Market cycles include economic cycles that consider expansions, recessions and inflation, trading conditions such as high volatility and low volatility, and market events such as wars, pandemics and other black swan events,” he explains. “As a rule of thumb, investors should expand their investment universe as wide as possible in order to access more strategies to build a robust portfolio.”
“That’s why it’s important not to focus too narrowly, but to spread investments across a range of sectors and markets, reducing the risk that any single downturn will have too big an impact,” adds Eoghan O’Hara, country head of Raisin Bank. “Diversification is a very sensible approach. Think of it as a way to shield yourself from potential market shocks.”
If someone is looking to build a balanced portfolio, O’Hara says the first step should be to speak with a financial planner who can tailor a strategy to their specific needs. “Property remains as popular as ever as a tangible store of value, while pensions continue to be one of the most tax-efficient and reliable ways to prepare for the future.”
Investors should also investigate whether their portfolio is truly diverse; for example, in recent years, the US stock market, as represented by the S&P 500, has performed exceptionally well, leading many investors to believe they are diversified through broad exposure to over 500 different companies. “But, in reality, this index has become increasingly concentrated and dominated by a handful of large companies,” Hurley warns.
“Today, the top 10 holdings make up nearly 40 per cent of the index. With this level of concentration, if this group of companies faces trouble, the entire portfolio could suffer significantly.”
Experts are keen to point out that building a diversified portfolio isn’t only for the big rollers – private markets have become accessible to a greater number of investors in recent years due to new fund structures that have been built for the private wealth channel, notes Rogers.
“From a public market alternatives perspective, these asset classes are becoming a vital component of diversified portfolios. However, the caution is that as you move to public alternative markets, there are fewer, desirable, passive investment options like in the traditional markets and therefore active manager selection is a core component of building out this foundational block.”
Investors will often structure their investments via a range of investment structures such as direct equity investment, use of regulated funds or life wrappers or investments via a corporate entity or partnership, which also helps from a diversification perspective, explains Alison McHugh, partner and head of private client services at EY Ireland.
But McHugh points out that an individual’s appetite for risk will often determine the split of their asset allocation across the various asset classes, and their risk tolerance is often driven by their age and the time frame in which they wish to realise the value from their investment portfolio.
“For example, for a person in their early 30s where cash is required in the short term, to buy a house or fund children’s education, it is more likely that the investments will be more heavily weighted in favour of lower-risk investments such as government bonds where the main objective is to protect the capital value of those investments,” she says. “However, for longer-term investments, they may be more willing for their asset allocation to be weighted more in favour of higher-risk investments such as direct equities that will yield a higher return.”
Conal Cremen, investment strategist with RBC Brewin Dolphin, says that, in a nutshell, stocks offer high investment return but come with more volatility, while bonds offer lower returns with less volatility.
“Bonds typically do better when the stock market falls, which helps reduce portfolio risk,” he says. “However, this is not always the case, as the traditional diversification benefit from bonds – negative correlation with stocks – can fail if inflation or interest rate hikes make correlations positive, as bonds lose their hedging role. We saw this in 2022 where all asset classes sold off in what was a very unique year.”
Hurley agrees, noting the market turmoil caused by the Russian invasion of Ukraine and the aftermath of Covid-related supply issues. “Rising interest rates, high inflation and increased uncertainty saw negative returns across many asset classes and, as a result, even diversified portfolios faced challenges,” he says.
But ultimately, the goal of a diverse portfolio is to avoid any catastrophic losses. “The vast majority of individuals have worked hard to accumulate their funds and view their investments as irreplaceable capital,” Cremen says. “Therefore, it is very important to avoid any permanent loss of this capital. By suitably diversifying your portfolio you significantly reduce the risk of enduring a permanent loss of capital.”
After a health scare, people tend to turn to a healthy lifestyle. This also happens with people’s investment portfolios, Rogers notes. “But best practice is to build and maintain a diversified portfolio through a full market cycle, so you are implementing a healthy lifestyle before the health scare occurs.”
