Portfolios can be made genuinely diversified through the selection of a mix of assets that exhibit low levels of correlation with each other. Should a geopolitical flare-up or macroeconomic shock trigger losses in one asset class, such as equities, owning other assets that tend to move in a different direction, such as government bonds, would probably help cushion performance on the downside.
A diverse range of investments should also enable portfolios to even out some of the peaks and troughs of the markets. This has a beneficial impact on retirement savings, because relatively smaller but more consistent investment returns tend to result in superior returns over the longer term. By contrast, larger moves up followed by smaller moves down tend to lead to inferior returns.
This underscores the importance taking a "top down" view to diversifying portfolios at the moment of deciding their asset allocation. Yet genuine diversification can only be achieved if this approach is combined with a "bottom up" view as well.
By picking a broad range of fund managers to run parts of portfolios, one can have investments across different fund-management styles, as well as in multiple regions, financial assets and industrial sectors. This is essential because we know the market does not always reward all styles, all of the time.
A further level of diversification is found at the level of security selection – ensuring that there are diversifiers within asset classes.
Finding securities that provide an income is key to building portfolios for retirement; certain stocks that have a long history of paying out much of their earnings to investors are often favoured. Before the financial crisis, shares in UK banks were a favourite to meet this challenge.
But having too great an exposure to these stocks would have wrought havoc on a portfolio during the financial crisis. Bank share prices were battered, while the only payouts a number of the largest went on to make went to the government, which had been forced to bail them out.
It follows that just as diversification is essential in crafting the right portfolio for retirement, it should be achieved in the right way – rather than just diversifying for its own sake.
During a strategic asset allocation process, for example, fund managers can take forward-looking estimates for risk, return and correlation to produce thousands of trial portfolios. This helps avoid "tippy" portfolios – situations whereby small changes to input assumptions lead to wild variations in the outcomes.
