Diversification in investing: the old rules no longer apply

A diversified portfolio was once a straightforward way for investors to respond to escalating market uncertainty, but not any more. We outline the new rules.

If history is any guide, we may be nearing the end of a strong run in stock and bond markets. At more than 3,450 days, the bull market run in equities is already the longest in history and bond markets have started to roll over. There are sound reasons for this: interest rates are rising, valuations are high and the geopolitical environment is increasingly uncertain.

New conundrum

The correct response to this new climate, according to much of the investment management industry, is diversification. Much has been made of the power of diversification, which was famously branded ‘the only free lunch in finance’ by economist Harry Markowitz. And who doesn’t like a free lunch? At its heart, diversification simply entails holding a range of assets so that as some go down, others rise, giving an investor a balanced return over time. In theory, investors could simply hold some bonds, some equities and perhaps a bit of property, sit back and watch their investment gently rise in value.

Only it’s not quite that simple. Holding a ‘balanced’ portfolio of bonds and equities used to work pretty well. Bonds tended to do well in a weaker economic climate, while equities typically thrived when the economy was expanding. However, the various interventions of central bankers since the financial crisis have changed all that. Quantitative easing put lots of money in the system, creating demand for financial assets and pushing up stock and bond markets in unison. Those with a balanced portfolio did well, but not because they were diversified.

The danger is that as emergency monetary policy measures are withdrawn and interest rates rise, the opposite happens: bonds and equities drop in unison. Those who thought their portfolios were diversified find that they aren’t.

Mark McKenzie, head of alternatives research at Thomas Miller Investments, says: ‘The old rules have changed slightly. If we look back prior to 2008, a 50/50 split of bonds and equities didn’t do too badly. Any sharp decline in equities was offset by bonds; but the diversification benefits of traditional models have dwindled. The question becomes how to mitigate against increasing risk from traditional portfolios.’

This problem is also very apparent with income-seeking strategies. When interest rates are low, investors may look to replace the income they were previously getting from their savings accounts with stock or bond market investments. This can push up parts of the stock market that are seen as providing a safe income, as well as corporate bonds that pay an attractive income. The danger is that when interest rates rise, all those stocks and bonds sell off in unison because the same income can be achieved with lower-risk assets. Markets are not there yet, but there are signs that these assets have started to wobble.

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