Diversification: Reducing Portfolio Risk
Building Long-term Wealth Requires Efficient Diversification
Investors' capital is exposed to a number of risks, from volatility and correlation, both of which are market risks, to asset-specific, macroeconomic and?geopolitical risks, and even long-term risks like climate change. Efficient capital allocation requires more than just delivering returns:?investors should also seek to?deploy capital in a way that protects them against these potential headwinds. The way to do so is diversification. Diversifying efficiently could make all the difference between building wealth and losing it.
Leverage is often viewed as bringing more risk into the investment process. However, as Man Group demonstrates, leverage can also be used to enhance a portfolio's return profile. The overall risk of the portfolio could be improved and be more balanced when compered to a classic 60/40 portfolio.
The CAPM is the first formal asset pricing model developed by financial economists. It has several flaws, however, including the fact that it predicts a positive relationship between risk and return. What does this mean for portfolio diversification?
In recent years, interest in green investing has risen as investors have become more aware of the risks posed by climate change. Green bonds are a way of diversifying portfolio risk while also contributing to a cleaner planet.
Credit markets can offer an element of diversification to investors' portfolios. However, several macro forces – inflation, government spending and monetary policy – can impact the dynamics within credit markets which can diminish their capacity to be efficient as diversifiers.
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Reducing a portfolio's beta has to do with reducing the correlation risk. How can investors best achieve this? And can they learn from past events to better position their portfolios?
Investors can diversify within the same asset class, across asset classes, as well as across geographies. This paper focuses on the latter element of diversification by bringing into focus private markets.
Mutual funds can offer investors the international exposure they need in order to reduce overall portfolio risk.
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FactorResearch provides an example of how various risk mitigating elements can be brought together and diversify the portfolio.
Building a portfolio for the long term requires investors to think of the big trends likely to affect economies and capital markets in the years to come.
Low volatility can be an indicator of positive long-term performance. Looking at what regions display low volatility in order to diversify one's portfolio can therefore be a good strategy.
Considerable market drawdowns (falls in prices from peak to trough) can have a significant negative impact on wealth. Learning how to avoid such risks remains a must for investors who want to protect their long-term returns.
Typically, investors are worried about bonds and equities moving in the same direction – correlation risk. This paper concludes that even within the commodity markets, comovements pose a risk.
Low-beta and low-volatility strategies can play a meaningful role in reducing the overall portfolio risk. Investors ought to consider these approaches to asset allocation as part of their efforts to diversify.
This paper uses VaR – short for Value at Risk, the industry's standard for measuring risk – to assess the behaviour of mutual funds on the Saudi Stock Exchange between June 2017 and June 2020. Its results may be of interest for investors seeking to diversify their portfolios with international exposure.
ABOUT THE AUTHOR
Andrew Perrins is a former Actuary and Asset Allocator. After qualifying as an Actuary, he worked for 15 years in investment management, serving as Director of Asset Allocation for Abbey Life and for Chase Manhattan, before setting out on a more entrepreneurial path.
To contact him,?email?[email protected]