Achieve a true diversification benefit in your investment portfolio with these tips
By Montag & Caldwell
June 5, 2020
Selecting asset classes for your portfolio may be the most important decision you make when it comes to achieving your financial goals. Academic studies, such as Brinson, Hood, and Beebower’s Determinants of Portfolio Performance, show that portfolio returns are dominated by asset allocation decisions. Asset allocation is designed, predominantly, for diversification — which is used as a risk mitigation strategy. In other words, the goal is to combine assets with low correlations, which should in turn, lower volatility.
Correlation is simply a way to measure how different investments move in relation to one another. When assets move in the same direction, at the same time, they are considered highly (or positively) correlated. To reduce volatility in your portfolio, it is generally preferable to have asset classes with a low (or negative) correlation.
The table below illustrates this concept in each of the past five down market environments. We included the following indices and returns: Russell 1000 (large cap stocks), the Russell 2000 (small cap stocks), the Russell Midcap (mid cap stocks), MSCI:EAFE (international stocks), Long / Short Median Manager Returns (alternative investments), HFRI Equity Hedge index (hedge funds), and the Bloomberg Intermediate Gov/Credit A+ index (high-quality fixed income). The indices are unmanaged proxies for performance and characteristics. Long/short median returns are actual gross of fee returns from a consultant database.
As the table shows, the equity asset classes (large, small, mid cap and international) are positively correlated — meaning that they have largely moved in the same direction, providing little diversification benefit. The addition of alternative investment strategies, while less positively correlated, are still positive and have provided little assistance in capital preservation. In addition, the alternative allocations tend to be smaller and often have little or no liquidity (the inability to sell assets quickly), coupled with high fees that may compound the ineffectiveness of the allocation.
The one asset class that is consistently negatively correlated, and therefore offers better diversification benefits through capital preservation, is high-quality fixed income (bonds). Fixed income securities, particularly higher-quality bonds, are ideal for protecting asset values, helping to smooth out market extremes. During market downturns, investors tend to gravitate towards the safety of bonds, but high-quality bonds in particular, as they have lower probabilities of default.
A logical allocation goal is to minimize risk while meeting a required level of return. The impact of market volatility is significant, and if not mitigated, can severely degrade the portfolio’s ability to achieve its required objectives. In addition to providing income, bonds play a key diversification role in helping to reduce negative impacts of stock market volatility on overall portfolio returns.
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Montag & Caldwell, LLC was founded in Atlanta, Georgia in 1945 and has served both private clients and institutional investors for 75 years. While primarily known for managing equity securities, our firm’s experience also includes fixed income and asset allocation strategies – with an emphasis on managing risk.