As a risk-reducing strategy, diversification has earned its place as one of the golden rules of investing. Yet, it often seems to fail to protect just when investors need it most — during a market crash. That’s because in volatile times like we experienced in March, historical correlation patterns break down and prices for asset classes that once moved more-or-less independently fall in tandem.
John Petrides, a portfolio manager with Tocqueville Asset Management, notes, “The period we’re seeing now is similar to the 2008-2009 financial crisis where we saw volatility pick up to the point where all asset classes outside Treasurys, cash and gold correlating to one.” Petrides explains, “There are many reasons why that happens, including panicked selling in riskier areas of the market, but also investors selling less risky assets in order to meet margin calls. Those kinds of factors can drive all asset classes to move in a similar downward direction.”
But while diversification may not always protect in a market rout, it remains an important tool in our current environment. In times of uncertainty, especially, diversification offers three critical benefits to investors:
1. Risk Management
With any investment, there is always a tradeoff between risk and return. Diversification can reduce risk in the form of volatility through the creation of a portfolio with assets that have low or negative correlations. To dig a little deeper, a sound diversification strategy helps eliminate unsystematic (company-specific) risk – a risk for which your clients aren’t compensated. In other words, if your clients aren’t adequately diversified, they’re taking on risk that doesn’t add to their return potential.
2. A Wider Net for Returns
Diversification helps clients cast a broader net to capture both economy-wide and company-specific growth. By its nature, a diversified portfolio will never top the performance charts, but it won’t be at the bottom, either.
The chart below makes a few points in favor of diversification. First, it shows that it’s virtually impossible to consistently predict which asset classes will outperform in a given year. Second, it shows that a diversified portfolio (the white “Asset Alloc.” boxes below) is less volatile than a concentrated portfolio would be. As a comparison, note how small caps (orange boxes) and emerging markets equities (lilac boxes) have had a much wider range of ups and downs.
3. Peace-of-Mind Dividends
By offering a smoother, less volatile ride, diversification can help clients stick to their financial plan in times when panicked selling is a temptation. Even more so than bear markets, emotional decision making is the greatest threat to your client’s financial future.
A Few Caveats