‘7-point plan’ for staying patient: Diversify … but do it intelligently

In Get Real, we discussed the challenges of investing in a low return environment. Then last week in Australia we witnessed two important ‘historic lows’: the Reserve Bank of Australia cash rate at 1.5%, and the 10-year government bond yield at almost 1.8%. Against the backdrop of volatility and sluggish economic growth, those assets that are perceived to be defensive continue to enjoy unprecedented levels of demand. This flight to safety, encouraged to a large extent by the never ending quantitative easing, has many investment experts worried. In the press, the legendary bond investor Bill Gross is saying government bonds, traditionally thought of as one of the safest investments available, “aren’t worth the risk” and therefore not top of his shopping list right now.

So…wait a minute… some of the world’s safest investments have now become (thanks to their extreme valuations) some of the riskiest? What does that do to a portfolio that is half bonds and half the ‘conventional’ risky asset – equities? Should such a portfolio still be considered diversified? On the surface, it is of course diversified. But in a complex and distorted asset valuation environment, we encourage investors to take a look at their portfolios and consider diversification not in name only, but from the point of view of the actual contribution to overall portfolio risk that any investment brings in. In other words, try to think about how your investments will behave when something destabilising happens in financial markets. What are the chances your fixed income and your equities lose value at the same time? If you, like Bill Gross, are concerned this could happen, you need to look at widening your investment menu to include alternative, or different, sources of return less correlated to what you already own. Diversification truly means something only if the components of your portfolio behave differently in adverse market conditions. Otherwise, it is just another theoretical construct.

To us, diversifying intelligently means providing our clients with access to as broad an investment menu as we can: equities, various flavours of fixed income (including credit, high yield, emerging market debt), real assets (property, infrastructure, commodities), non-directional absolute return strategies, and volatility strategies. It also means less reliance on passive management and static asset allocations, and more reliance on active strategies designed to limit the downside risk. For instance, we frequently use currency hedging as a risk management strategy, alongside the traditional put option portfolio protection. All of these elements make portfolios more resilient but they require a degree of institutional expertise to implement. This is where we get back to our consistent message – finding a reliable investment partner is crucially important.

Having them do the heavy lifting will have the added benefit of letting you focus on guiding your clients towards their strategic goals. We will speak more about this next week.

This article forms part of the 7-point plan for staying patient series.