Diversification: A hedge against market uncertainty

I hope by now, nearly every investor has heard the same advice: Diversify your portfolio. After all, if you have all of your equity eggs in one basket – let’s say oil – how would things have looked over the past 18 months? Not good. The same is true with keeping all your fixed-income eggs in a single basket– emerging market debt has been an ugly place to be, for example.

Still, diversification for its own sake may not give investors the combination of returns and risk protection they need. Here at Russell Investments, we firmly believe that one of the keys to the “right” kind of diversification is to have a clear set of beliefs and expectations about markets, and allocate asset purchases accordingly. I wrote about this back in April. And it’s a topic many of our top people have blogged about often throughout the course of 2015.

In October, for example, Scott Bennett wrote about how a momentum strategy can add diversity to a portfolio. What is “momentum?” It’s a trend-following strategy that takes advantage of predictable human behavior: We tend to go along with the crowd. So if a stock or other asset is heading up – or down – people usually follow along. Some investors shy away from taking advantage of momentum because it seems, against everything most people learn about markets and it isn’t without risks. But momentum investing is one of our core beliefs, and we think that considering a momentum component as small part of a portfolio can add potentially worthwhile diversity.

Another place to diversify is to consider the tax exposure of your investments. One of our tax experts, Frank Pape, wrote about strategies for reducing taxes on capital gains. It’s more complicated than just buying muni bonds and calling it good. Instead, as Frank points, out, investors can take several approaches to reducing capital gains. Diversification is a key component, as a diversified portfolio comes with the assumption that some assets will go up, some down. As Frank notes in another recent post, a tax-aware investor can potentially “harvest” any losses incurred during the year and use those to offset capital gains taxes from assets that performed well.

A third reason to build diversity into a portfolio is as a potential hedge against volatility. Tim Noonan wrote about that approach in May. What he said then remains true: We see U.S. equities as close to their peak, while a U.S. Federal Reserve interest rate hike – back then foreseen for September, now seemingly likely in December – will start to turn off the stimulus spigot. In Europe and Japan, meanwhile, potential new rounds of quantitative easing will likely give economies there a profile similar to what the U.S. had in 2012.  As we’ve seen, bad news out of China, geopolitical shocks, currency swings – all of those things could upend what seems like an easy call.

These factors might lead one to conclude that it is important to be “all in” on Europe and Japan. However, as we all know, there are few certainties in this world beyond death and taxes. That said, one of the best ways to help a portfolio is to hedge some of our convictions by remaining broadly diversified. As you can see, we think about diversification a lot. Our goal is to really understand what makes diversity “tick” for investors, and to show advisors and investors how a well-considered approach to diversifying a portfolio can help to deliver solid investing outcomes.