Diversifying your portfolio is the only free lunch in finance

Economist and Nobel laureate Harry Markowitz famously called diversification the “the only free lunch in finance”.

This is especially true in periods of market uncertainty, when virtually all asset classes are falling in unison.

“Markets have been more volatile than investors are accustomed to over the past decade,” says Carla de Waal, multi-management and manager selection Head at FNB Wealth and Investments.

“The size of the moves of different asset classes has been more extreme, with bigger moves to both the up and downside, plus right now there’s a lot of negativity in the market.

“Sentiment is sitting at the extreme fear end of the spectrum. Investors are not used to this kind of perfect storm,” says De Waal.

“At times like these, it is essential to be well diversified across different asset classes and geographies.”

The leading equity indices are bleeding red across the board. The Dow Jones Industrial Index is down 16% since the start of the year, the Nasdaq is down 30% from its November 2021 peak, and the JSE All Share Index is down 13% from its March 2022 peak.

What prompted this change in outlook?

“Several things have impacted the general outlook of investors, including the inflationary environment,” says De Waal.

“Investors are definitely more nervous. Last year people thought inflation was transitory, now it seems longer lasting. The war in Ukraine is certainly pushing inflation higher, to levels that many people have not seen in their lifetimes. The last time it was this high was in the 1970s in the aftermath of the oil crisis. The US Federal Reserve’s toolkit is essentially limited to raising interest rates, and in June this year it bumped up rates by 75 basis points. The question that now arises is whether this pushes the US and the world into recession.”

More defensive asset classes have also been driven into negative territory, alongside riskier asset classes such as global equities, which are down more than 20% since the start of the year. By the third week of June, global bonds were down 15%, local equities down 9% year to date, local bonds are flat, and domestic property is taking water.

“It’s difficult to find safety in any of this,” says De Waal.

Russia was removed from certain international indices, and SA benefitted by being up-weighted in these indices. That cushioned domestic markets from what would have been a more severe drubbing, and local bonds in particular held up well, largely because SA’s terms of trade were lofted by higher commodity prices.

During the recent Moneyweb Better Investor Conference, De Waal outlined the BEST investment strategy as a useful guide for investors in times of uncertainty.

The BEST investment strategy

BEST stands for Behaviour, Experts, Spread and Time.

Behaviour as an investor. “This is the only thing you can control, because you cannot control the markets. People are driven by emotional factors such as loss aversion, and there is research to show that people feel a loss more than a win. So they will switch and change midstream and that has been shown to negatively affect performance,” says De Waal.

Experts. “It helps to have a financial planner who is not emotionally invested in your situation. As an investor you are often at an information disadvantage relative to the professionals. There’s not enough time to know everything about the market so you can use a multi-manager or financial advisor to help you with modelling of assets to get the best combination for your objectives, monitoring the people who manage your money. Having an expert at your side is definitely advisable,” she adds.

Spread or diversification – the only ‘free lunch’ in financial markets – is the best way to spread risks across sectors, assets and geographies. “This year equities and bonds have been weak at the same time, so it may be time to look at alternative investments such as commodities, gold and non-correlated assets,” says De Waal.

Time. It’s not timing of the market, but time in the market that produces sustainable returns. It is better to stay invested in the market, even during pullbacks as we are currently experiencing, as very few investors can predict when the market cycle will turn. “By staying in the market, time and compounding work in your favour,” says De Waal. “The problem arises when you are – as we are now – 20% down, and it looks like we are not going to beat our inflation targets.” A good example of the folly of trying to time the market is the Covid crash and recovery in 2020. Those who sold early into the crash very likely missed the recovery, thereby compounding their losses.

“Investors need to stay invested in the market, which means you will suffer pullbacks, but you will also participate in the full recovery,” she adds.

There are strategies that help investors to profit from declining markets, but you do not want to be switching into a new strategy midstream. It is better to spread your portfolio at the start.

Cash and gold as safe haven assets

Part of any well diversified portfolio should include some exposure to safe haven assets such as cash and gold. This is particularly true given the threat of global recession coupled with higher inflation (stagflation).

“We believe gold is a good diversifier, while others look at cryptos as an alternative. We haven’t found a good enough reason to bring cryptos into the portfolio at this stage,” says De Waal.

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Brought to you by FNB Wealth and Investments.

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