The art of diversification in a volatile market

Each stage of the process requires different investment approaches. Whether a portfolio meets your goals for return and risk depends on a key step in the investment process called asset allocation. Asset allocation determines the appropriate mix of the different risky (stocks/commodities) and risk-free (government bonds) asset classes in a portfolio. In essence, there are two important asset-allocation aspects of the investment process: strategic and tactical.

“Strategic” refers to portfolio allocation across asset classes such as stocks, bonds, commodities, real estate and cash; regions – US, Europe, Japan, Asia etc – and financial: market segments such as banks, mining, pharmaceuticals etc as deemed suitable for an investor with a specific risk profile over the long term. 

The goal of diversification is to improve the portfolio’s risk-versus-return trade-off. Diversification reduces the risk level of the portfolio for a given expected return, or it facilitates a higher expected return for a given level of portfolio risk. It is based on long-term assumptions about market behaviour. 

Let’s say for example there are three portfolios, A, B and C. Portfolio A is the most conservative with an asset mix of 85 per cent risk-free assets such as government bonds and 15 per cent risky assets such as stocks, commodities and corporate bonds, both onshore and offshore. Portfolio B is slightly more risky with a 70:30 mix between risk-free and risky asset classes, whereas, C is tilted towards growth with a 50:50 mix.

Because of the different mixes of assets among the three portfolios, they have different levels of risk and expected return. Portfolio A, the most conservative of the three, has an expected return of 3.7 per cent per annum but in a really good year, it can yield as much as 8.5 per cent and in a really bad year the expected return can be negative-1.1 per cent. Portfolio C, on the other hand, has an expected return of 6.1 per cent, or twice that of A. And in a really good year, the return can be as much as 15.9 per cent, while in a really bad year, the loss can be as much as 3.7 per cent. 

As you can see, the range of expected returns (risk) of C is much wider than that of A, while that of B lies somewhere in the middle between of A and C.

According to several research papers, more than 90 per cent of a portfolio’s return variability can be attributed to the way in which the underlying assets are allocated. Your decision among portfolios A, B and C really depends on four main factors: your expected return, risk tolerance, investment horizon and your investment outlook. Portfolio A’s composition may not be optimal at a specific point in time, such as during a bull market when stocks and commodities are doing well. This is where “tactical” comes in. The purpose of the tactical aspect is to tilt the allocation towards asset classes and markets that are expected to outperform the rest of the portfolio, while reducing exposure to those that are expected to underperform. In combination with stock selection, tactical is also known as “active investment management”. 

In many ways, the tactical approach is easier said than done. A shift to tactical is often driven by emotion – greed and fear. The key factor to decide between the two, or a mixture, is the time horizon. If you have 20 years to invest, you can afford to take more risk. You should not mind too much to lose money in the short term because you have time on your side and possibly will make it back before retirement. But if you only have two years before retirement, then your situation is completely different and you would not be in the position to take as much risk. 

A thorough understanding of your profile is crucial to determining which particular portfolio, A, B or C, is suitable for you. If you approach your investment purely from a return point of view, the most tempting choice is to go for C because it has the highest expected return. But you must not forget that a coin has two faces. In order to achieve high return, you must be able to accept higher risk or volatility. 

In the “tactical” aspect of asset allocation, you are likely to sell during market fluctuations and may never realise your return targets. In the “strategic” aspect, where your expectations are in sync with risk and return, your targets will more likely be met over time.

 

Vira-anong C Phutrakul is managing director and retail banking head at Citibank, NA.