Three diversification mistakes – and how to avoid them
It’s important to understand the common mistakes investors make around true diversification, and what they can to address them.
All SMSF investors should have diversification at the core of their approach. Diversification – the notion that investing in a basket of differentiated assets helps protect portfolio returns – is one of the best ways to address risk in a portfolio.
But it’s not easy for SMSF investors, who often have limited assets, to achieve true diversification. Therefore, it’s important to understand the common mistakes investors make around this, and what they can to address them.
1. Don’t put too much weight on historical correlations
Many investors hold the view that when certain asset classes show little historical correlation, they offer great diversification benefits. But actually, when markets come under stress, returns from many common growth investments rise and fall in tandem and correlations rise..
An example is equities and commodities. In the past (years before the GFC) there was a view in markets that these two asset classes were not highly correlated. As a result, as commodity prices rose investors also increased their exposures to commodities, partly for an assumed diversification benefit. But when the economic conditions became challenging the commodity market and equities market fell together demonstrating how correlation between these two asset classes can change.
In this case, diversification failed when it really mattered, impacting all investors. The message for SMSF members is not too put too much weight on historical notions of diversification and correlation and instead to look at current market dynamics for true sources of diversified returns.
2. Remember macro factors affect asset classes in similar ways
In the same way investors erroneously assume the way diversification was approached in the past is appropriate for current market conditions, many also forget that the same macro drivers are likely to affect different asset classes in the same way, even when the source of their returns are uncorrelated.
For instance, different drivers affect equities and property assets in different ways. For instance, when interest rates rise, this may be positive for equities such as bank stocks, but negative for property investments given this makes borrowing to invest in real estate more expensive.
But while different drivers affect these two asset classes, and therefore they should provide a diversification benefit, other factors can mean their performance rises and falls in tandem.
An example is geopolitical events. Major news, for instance the UK’s ‘No’ vote to stay in the European Union, affects many asset classes in the same way. When this happened the value of many investments including equities and European currencies fell in tandem.
To avoid this, it’s essential to have a full appreciation of how macro factors such as geopolitical events will affect all the assets in the portfolio, and construct the fund with geopolitical forces in mind.
3. Don’t forget risk
TThe third most common diversification mistake is constructing a portfolio that appears diversified based on individual asset class weights, but not far from risk diversified.
For instance, investors may make various allocations to different asset classes for the purposes of diversification, but forget to account for risk. The portfolio may appear to be balanced because it has a diversity of income sources. But not accounting for risk in this process may expose the portfolio to unnecessary volatility.
For instance, it’s important to allocate a portion of the portfolio to defensive assets for diversification and risk management purposes. But at the moment finding well-priced defensive assets is tricky. This has prompted some investors to take positions in higher-risk fixed interest assets such as hybrid bonds.
These financial instruments share some common properties with equities, and they also share some of the same risk characteristics as shares. So diversifying into hybrid securities may inadvertently increase the fund’s risk profile, when the purpose of taking a position in these investments was to diversify the fund’s exposures and enhance its defensive component.
Diversification is something that requires constant vigilance and an appreciation of how market events may impact portfolio returns.
The idea is for SMSF investors to look and between within asset classes to avoid unintentional correlation to help protect portfolio returns under different market conditions.
About the author
Nader Naeimi, Head of Dynamic Markets at AMP Capital. He is also the portfolio manager of the Dynamic Markets Fund.
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