Don't put all your eggs in one basket. The old saw and its implied consequence that otherwise, the eggs might all be broken at once, is the basic principle of risk diversification in investing. Since individual financial assets entail different risks, their prices do not move in sync. Thus, by combining them, it is possible to reduce a portfolio's overall volatility. The more imperfectly correlated securities one adds in, the closer risk tends towards its minimum level. Risk-spreading is therefore a compelling tool for investors who seek steady returns and capital protection.
Don't forget that correlations and volatilities are unstable
Although the underlying principle is clearly valid, diversification based solely on correlations and volatilities first of all has certain limits or, at least, imperfections. Performances have often fallen short of investors' expectations when portfolios that incorporate this approach have confronted the financial stress periods observed in recent years.
This is because correlations and volatilities have proved unstable. They have surged in crisis periods and, in so doing, have crimped and even wiped out the very benefits of diversification that the portfolios' architects were striving for. Thus risk tends to be underestimated, and this can lead not only to a false sense of security but also to portfolio construction that is less than optimal.
Rushes into safe havens
Second and more importantly, just because two assets that are weakly correlated does not mean they have the same intrinsic source of risk. Two stocks which in normal times are moderately correlated are both sensitive to the movements of the equity market as a whole. In the event of financial stress, investors will sell their shares indiscriminately and scramble into safe havens. Thus the two stocks in question will fall in price symmetrically, making them perfectly correlated. Diversification evaporates and losses are larger than expected.
Safe assets, in contrast, will increase in price, even if their expected return is negative. One of the impacts of this perversion in a financial crisis is that the average loss typically exceeds the gains that an investor can chalk up when the markets are moving normally. Unfortunately this has been the rule for a number of years now.
Sensitivity to ups and downs
Financial markets zigzag between periods of euphoria that are a hotbed for risk assets and bouts of stress, when safe havens thrive. In the low interest rate environment we have now, it is tempting to favour assets whose expected returns are in line with the minimum level investors can reasonably hope for. Sadly, portfolios that are heavily exposed to risk assets such as equities have become less stable and more sensitive to the markets' ups and downs.
Identify the sources of risk
So how does one build a portfolio that is both diversified and, more importantly, resistant? It is first of all necessary to identify the sources of risk and gauge the contribution of each to the overall risk level. This is a quantitative exercise which can consist, for example, in measuring a portfolio's dependence on equity risk via all the asset classes. One finds out that this relationship exists with not only in hedge fund and long-only strategies but also with convertible and high-yield bonds. The aim of intelligent diversification must therefore be to avoid concentrations within a limited number of risk factors.
In a portfolio, the risk factor allocation can be very different from the asset allocation
Devising investment scenarios
Beyond breaking down risks, shrewd investors work out economic scenarios, evaluate the probability of their materialisation and gauge their expected impact on investment choices. It is the various reactions of financial instruments to such scenarios that will decide how they should be weighted.
Armed with this information, an investor will probably want to buy sovereign bonds or gold for the sole purpose of reducing his portfolio's risk level, even though he knows their expected return is low. Yet risk management takes in more than mere diversification. A robust portfolio has to contain investment strategies that will mitigate its loss in the event of a severe shock. These mainly include hedging strategies, which should preferably be implemented when the markets are calm and insurance premiums are low.
Finally we should remember that diversification based only on statistics, such as correlations and historical volatilities, is ill suited to today's financial markets. It is possible to build portfolios that are more stable and robust in the long run by using an approach that incorporates intelligent analysis of risk sources and investment scenarios.
Edmond de Rothschild (Suisse) SA
Head of Discretionary Portfolio Management & Deputy CIO
This document was published by Edmond de Rothschild (Suisse) S.A. ("EdR"), 18 rue de Hesse, 1204 Geneva, Switzerland, a Swiss bank authorised and regulated by the Swiss Financial Market Supervisory Authority (FINMA). The information and data contained herein do not constitute an offer or a solicitation to buy, sell or subscribe securities or any other financial instruments. The information, advices or assessments contained in this document reflect a judgement at the time it was published and may be changed without prior notice. Before taking any investment decision, investors are advised to seek advice from a professional. Every investment entails risks, particularly the risk of fluctuating prices and returns.