Shock horror! Milliman says that diversification may not deliver what we have thought it would deliver since way back, since the dawn of Modern Portfolio Theory, when we were kids. A new study shows that investors need a ‘multi-layered’ approach.
Michael Armitage, the Sydney-based head of fund advisory services for consulting firm Milliman, says diversification is just one risk management tool – not a comprehensive risk management solution.
Multiple asset classes won’t lower portfolio risk when the same factors drive each asset classes’ investment returns. Armitage says:
“Diversification cannot provide protection against systematic risk, such as a global recession, when all major asset classes tend to fall in unison.
“Derivatives such as futures, which offer significant liquidity and transparency, can be used as a cost-effective second-layer safeguard against volatile markets and potential capital losses.
“Risk comes in many forms but investors are acutely aware of two: the impact of capital losses and extreme bouts of volatility. Both can have a devastating impact on a portfolio.”
He says that capital losses, such as happened in 2008, may never be recouped by some older investors. Meanwhile, volatility can prompt investors to withdraw their money at just the wrong time or quickly erode a lifetime’s savings when an investor is drawing down their capital.
“The solution offered by the financial services industry typically involves well-intentioned advice to stay invested for the long-term and diversify your portfolio,” Armitage says. But, while such recommendations have merit, they also ignore several shortcomings of diversification.
“Diversification has been a central tenant of portfolio construction since the early-1950s when Harry Markowitz developed Modern Portfolio Theory. It tells us that investing is not just about picking the right asset classes. It’s also about selecting the right combination of asset classes.
“Most investors understand that by combining a range of asset classes with low correlations – spreading risk around – overall portfolio volatility can also be lowered.
“Unfortunately, the practical implementation of this concept leaves much to be desired. Investors have all too often found that when ‘growth’ assets decline, their entire portfolio slumps, and that the correlation between ‘growth’ and ‘defensive’ assets is often greater than they believe.
“This is because the investment returns of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.
“So, while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.”
* Greg Bright is publisher of Investor Strategy News (Australia)
