Skip to the content

The return(s) of diversification

29 September 2016

Goldman Sachs Asset Management’s James Ashley explains why maintaining a well-diversified portfolio is as important as it ever has been.

By James Ashley ,

Goldman Sachs Asset Management

For several years, it has been challenging even for professional investors to stay diversified. Pure equity market beta has outperformed a well-diversified approach by historic margins in recent years (see table below).

In this context, clients sometimes tell us it has been tempting to succumb to ‘recency bias’, meaning the tendency to over-emphasise the recent past. This tendency today may come at the expense of a well-diversified approach to portfolio construction.

We would stress that the recent past has been historically unusual, even aberrational.

The three consecutive double-digit S&P 500 index gains investors enjoyed in 2012-14 have been matched or exceeded only four other times since the start of S&P data in the 1920s.

The good news is recent performance shows hints of more historically ‘normal’ patterns of investment returns.

Ranked calendar year returns for key stock market indices 2006-H1 2016

 

Source: Goldman Sachs Asset Management

The first half of 2016 saw asset classes such as emerging market debt and equity, high yield bonds and bank loans outperform US large cap equities.

We see select areas of emerging markets debt as attractive, especially in the event of a ‘lower for longer’ interest rate environment, and we think the US real estate market remains firmly in an expansionary phase.

These trends, should they persist, are good news for would-be diversifiers, since the risk-adjusted returns of these asset classes when combined in a portfolio historically have been higher than those of US equities alone.

But beyond the encouraging 2016 trends, we think many investors fail to appreciate the heavy risk concentration created by an overreliance on a single asset class.

This risk concentration shows up even in some portfolios often viewed as well diversified. Let’s illustrate the point with a portfolio comprised 70 per cent of ‘core’ equities and 30 per cent global government debt. This 70/30 portfolio is sometimes viewed as well diversified if it includes several different types of equity allocations.

But this is not always the case.

To see how, consider that a hypothetical portfolio spreading the 70 per cent of core equities across UK equity, Europe equity ex-UK, US equity, Asia-Pacific equity ex-Japan, and Japan equity has still derived substantially all of its risk (more than 99 per cent) from equities.

The 30 per cent core bond allocation did not diversify the portfolio perhaps as well as some would expect.

Why not? Even seemingly dissimilar parts of the equity markets such as UK equities and US equities are large, widely owned asset classes, which historically have exhibited high correlations in their returns.

In the effort to adapt, we return again to a more expansive set of asset classes in the search for attractive risk-adjusted returns. More broadly, it is difficult, if not impossible, to predict the outperformance of a given investment in a given year.

Particularly at a time of elevated US equity valuations and shocks to the system such as the UK Brexit vote, we see merits in owning a diversified range of investments, to tap into the long-term returns of many asset classes and potentially limit overall portfolio volatility.

 

James Ashley is head of international market strategy, strategic advisory solutions at Goldman Sachs Asset Management. The views expressed above are his own and should not be taken as investment advice.

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.