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What a True Investment Portfolio Diversifier Should Accomplish

If there is one goal investors should pursue, it is having an investment portfolio that can stay strong regardless of the market conditions. No matter what our investment goals or strategies, we all face the same problem of uncertainty and risk. Instead of just accepting this uncertainty and hoping for the best, consider this: it is possible to build a portfolio that will perform well during the inevitable ups and downs of market cycles.

Asset Allocation Myths Debunked

Asset allocation is the most critical investment decision you can make. The various asset classes you invest in should work together to protect you from market storms and deliver a more stable performance over the long-term. But do you know the facts about asset allocation? 

The 60/40 Portfolio

Many people think that diversification is simply owning both stocks and bonds in a 60/40 balanced portfolio. But capital allocation does not distribute risk proportionately. In reality, more than 90% of the risk in your portfolio is related to your 60% in stocks. Therefore, if the stock market implodes, don’t count on your 40% bonds position to protect your portfolio by 40% when it really only mitigates around 5% of the risk. 

To go even further, even assets within the same class do not carry the same risk. For example, high-yield bonds tend to be more correlated to equity than sovereign bonds. If your 40% bond portfolio has 10% high yield-bonds, then your bond portfolio may behave more like your stock portfolio in terms of risk. 

Geographical Diversification And Correlation

Two different asset class can thrive together in an environment when the economy is strong, such as the S&P 500 and high-yield bonds. But issues arise in down markets because they are highly correlated, meaning that as one asset goes up or down, the other follows suit, bringing more risk to your portfolio. Correlation tends to increase during crisis times or when stocks drastically decrease, which is exactly when investors need correlation to be low in order to use it as a strategy to protect their capital. This is a scenario many investors experienced in the recent financial crisis.

 

How does correlation apply to geographical diversification? In the past, investing in international markets was a reliable way to diversify and protect your portfolio, but now that globalization has initiated growth to companies investing outside their own market and brought more correlation within developing and emerging markets, we need new tactics. For example, S&P 500 companies are currently generating more than 40% of their revenues outside of the U.S.

Regardless of how you have been investing, you need a better way to allocate your assets so that they thrive at different points in the economic cycle.

The Truth About Diversification

The worst part about diversification is that you don’t know for sure if you will be okay until the market starts to dislocate. During the nine years following the financial crisis, the 60/40 equity/bond portfolio has done well. But at the same time, we didn’t experience any disruptive events that would challenge this. Complacency has built up and we aren’t really worried about whether or not our portfolios are diversified enough to withstand a market meltdown. 

 

By adhering to the traditional diversification mindset, you could end up with the same negative results experienced years ago in 2000-2002 and 2008-2009. Confidence was so low back then that people stayed on the sidelines for too long after the stock markets rebounded. Anyone who didn’t lose substantially during this time period probably stayed invested during the downside and were the first to benefit from the market rebounding. Timing the market is a tough game, one that should not be played unless you are willing to take risks with your wealth. You want to stay in the market so you don’t miss the recovery period after a drop. 

 

Diversification should help you ride out turbulent times, but as you know, it doesn’t guarantee you won’t bypass the effects of down markets. Changes in economic environments occur slowly and are difficult to forecast, so make sure your portfolio is not built to only ride the up market but also able to handle the downside.

 

Another important thing to keep in mind is your investment time horizon. The longer the better, because some asset classes are great as diversifiers but they lack liquidity. If you need your money back to pay for an upcoming project (less than five years away), you should probably avoid those assets classes. But even though some classes have lower liquidity, that does not mean they are not liquid at all and not worse than most GICs (Guaranteed Investment Certificates). Lower liquidity may sometimes save you from trying to time the market.

Diversification Strategies To Consider

The question is, how can we diversify a portfolio enough to thrive through changing economic and market conditions? It is possible to better diversify a portfolio with alternative investment strategies or asset classes, but that doesn’t mean it’s a free lunch. It can be achieved by simply adding alternative investments or strategies and slightly modifying your current 60/40 portfolio profile. Or, it can be implemented more thoughtfully though with some liquidity constraints requiring longer-term investments. But that is true for index-like investing as well. No one can really achieve or capture the long-term performance of an index if their investment horizon is less than five years.

 

With these ideas in mind, you may want to look for real portfolio diversification where asset classes and strategies work together to reduce volatility or risk while trying to achieve the same level of expected return. Some strategies can be levered without unduly increasing the risk while increasing the expected return. Let look a comprehensive example:

 

Better diversified portfolios are not always feasible or achievable for smaller investable accounts, and it’s true that it’s way easier to implement with larger investable accounts. Moreover, some investments, like limited partnerships, are only suitable and accessible for accredited investors. Having said that, I believe most investors should be aware of what real diversification means and that it goes beyond the basic 60/40 investment model. A less elaborate portfolio than the previous example can be created and still be better diversified than the typical 60/40.  

Rely On A Professional 

Alternative investments can be complex, and strategies need to be well understood before being added to your portfolio. This is possibly why many financial advisors have stuck to the old diversification model and not always met the needs of their clients by not delivering strongly diversified investment portfolios. 

A financial plan is a long-term commitment that should line up with your investment time horizon. As a long-term investor, you should be concerned about the overall performance for the entire time horizon rather than any particular year within it. Having this perspective will increase your chance of better diversification and access to investments that have naturally longer horizons. It can be difficult and require plenty of discipline to stick to a plan, but if you don’t, no amount of diversification will deliver the results you desire. This is why it is essential to partner with an experienced and knowledgeable financial professional who looks out for your best interests, helping you stay the course when the going gets rough and building a portfolio that is unique to you. At Montag Private Wealth, we would be happy to provide a second opinion on your investment portfolio with no obligation. Book an appointment now

About Carl

Carl Martel is the president and portfolio manager of Montag Private Wealth. Along with more than 15 years of capital market experience and 10 years of experience in real estate hard assets, he is a Chartered Investment Manager® and holds a Certificate in Derivatives Market Strategies from CSI Global Education, a Masters of Science from Laval University, and an MBA from l’Université du Québec à Montréal. A focused and pragmatic, results-oriented investment professional and entrepreneur, he specializes in serving the unique financial needs of high net-worth individuals and families, foundations and endowment funds, and business owners. To learn more, visit http://montagprivatewealth.com/ or connect with Carl on LinkedIn.