The notion of modern portfolio theory was developed back in 1952 by US economist Harry Markowitz. At its heart is the principle that risk and return are directly linked. The more risk you take; the greater the return you should expect and vice versa.
It also introduced the concept that combining investments that are different helps manage risk and improve your return.
For many investors this second element seems to go out of the window when it comes to building portfolios. The results are often painful, as some may be finding out to their cost this year with the dramatic switch from growth to value.
When markets experience such a change in fortunes, it’s a great opportunity to see whether portfolios are truly diversified. I suspect many investors right now are beginning to realise that they are suffering from the illusion of diversification.
Too few investors lift the bonnet to see what is really going on within their holdings, or have a sufficiently detailed understanding of a fund managers investment process. In addition, I see many investors buying into investments that have already done well (and selling out of those that have done badly).
Investors then end up with a heavily skewed portfolio that may appear to be well diversified but which is ultimately exposed to highly correlated investments that offer very little genuine diversification at all.
Towards the end of 2021, asset manager Baillie Gifford looked at as if it could do no wrong. Its stable of funds and investment trusts had been performing incredibly well.
The heavy growth bias of Baillie Gifford drove the performance upwards as growth and technology stocks in particularly hit ever higher highs. Investors piled in with billions of pounds and the likes of Scottish Mortgage, Monks and Baillie Gifford US Growth rocketed.
I’ve seen many portfolios that had exposure to all of these trusts and then had some more technology and growth funds from other managers alongside.
Sure, they own some different companies in different geographies in different industries, but they will, in aggregate, have very similar characteristics in that they will be geared towards growth and a similar economic outcome. They are diversified by name but not much else.
Sadly, those investors are now learning a very painful lesson about the illusion of diversification.
That’s not putting the boot into these investments. On the contrary, we rate the investment teams running these strategies highly. But the key is understanding that they behave in a similar manner and therefore probably shouldn’t be combined into a portfolio.
The benefit of diversification in a portfolio comes from combining investments that perform well at different times. As a result, true diversification comes from having exposure to a range of asset classes, geographies, styles and industries.
If you get this right, then the danger of being buffeted by market rotations and volatility can be much reduced, hopefully improving both your journey and your long-term returns.
When it comes to portfolio construction, think of it as a jigsaw puzzle with each piece having a role to play in building a picture. If you understand what role each piece of your jigsaw is there to do, then you are already on the path to building a more resilient portfolio.
But it is vital to ask yourself ‘what if I’m wrong?’. What if your view of the economic outlook is too optimistic? What if inflation doesn’t go up as much as you think? What if we won’t all be driving Tesla’s in 10 years’ time?
It is these decisions that should inform your portfolio construction and fund selection to ensure you have built-in contingency. So when you look to build a portfolio, or review an existing one, ask yourself the ‘what if I’m wrong’ questions.
As Markowitz himself has said “a good portfolio is more than a long list of good stocks and bonds. It’s a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies”.
Ryan Hughes is head of investment research at AJ Bell. The views expressed above should not be taken as investment advice.