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What Diversification Really Means

Nick Samouilhan, multi-asset fund manager at Aviva Investors, puts the term “diversified portfolio" under the microscope.

As independent financial advisers come under increasing regulatory pressure to select suitable investments for their clients, constructing investment portfolios designed to meet clients’ investment goals becomes more critical. One important aspect of this construction process is diversification. However, while many advisers aspire to create “diversified” portfolios, the concept remains much misunderstood.

 

Diversification is often thought to be something that automatically happens as you add investments to a portfolio. This is incorrect. A better understanding is that diversification means having not just more, but different investments. While an improvement, it is important to think through what the word “different” actually means in this context. Indeed, this definition goes to the heart of what diversification actually is and what it adds to a portfolio.

 

Diversified sources of returns

Diversification plays two principle roles in the investment process. The first is to help client portfolios ultimately meet their long-term investment goal by diversifying the sources of returns in a portfolio, rather than asset classes.

 

Investment risk is rife and potential investment returns are almost never known with certainty. As such, portfolios should contain various allocations that individually can meet the desired investment goal, allowing the portfolio to still meet its ultimate goal even if your main view on the markets is incorrect. For example, splitting portfolio assets evenly between UK and US equities helps spread your chance of meeting a 10 per cent return target if either market disappoints. The aim is to combine investments that have a chance of delivering desired returns while insuring against your main view on the markets being wrong. Here, the focus is diversifying the sources of returns, not asset classes.

 

Diversification for path management

The second rationale and role for diversification has nothing to do with the long-term investment goal but everything to do with the path to achieving that goal. For instance, a 10 per cent return could be produced with a fund expected to generate relatively smooth monthly returns, or with one likely to fluctuate widely in value over the period. While clients should ideally be long-term investors and so focus on end goals and not paths, for some, paths matter. Indeed, clients may prefer portfolios offering less volatility (or smoother paths) over the life of the investment while sacrificing some of the potential returns.

 

Conclusion

Diversification plays two key roles in portfolio construction. The first is to provide many sources of returns capable of meeting the long-term investment goal under different market outcomes. In this respect, the correlation between asset classes in the portfolio serves little or no purpose. Diversification can also better manage portfolio volatility on the path to the end investment goal. Here, return expectations matter less while asset class correlations matter.

Understanding the different roles diversification plays in a multi-asset strategy can help advisers construct portfolios that behave as expected under a variety of market outcomes. In doing so, this helps advisers select suitable investments for clients in a portfolio that should be fit for purpose.

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