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How do experienced investors develop a portfolio diversification strategy?
Though one of the most commonly repeated idioms on the topic of portfolio diversification, the advice of “not putting all of your eggs in one basket” simply doesn’t suffice when strategising an adequately balanced portfolio as an experienced investor in 2021.
The considerable power of a well-balanced portfolio has long been recognised across the private investment sphere.
From Hood and Singer’s renowned ten-year 1991 pension fund study whose findings suggested asset allocation accounted for 91% of variation in portfolio returns, to more recent widespread analyses that have strongly merited the effectiveness of a diversified portfolio in minimising investment volatility throughout the 2008 financial crash, the evidence in favour is extensive.
But where portfolio diversification is now a well-adopted strategy for creating risk-balanced, healthy portfolios that have the ability to generate favourable returns, identifying the specific routes investors can follow to develop a robust portfolio diversification strategy can be essential for putting theory into practice.
Diversify by asset type
One of, if not the most fundamental aspect of portfolio diversification is spreading your investments so that your exposure to any one asset type is limited.
Over the last 20 years we have seen global “asset leadership” consistently fluctuate year-on-year. Where in 2018 international stocks were the best performing asset, in 2019 cash was supreme and in 2020 Real Estate Investment Funds - a pattern that has repeated itself over the course of the last two decades (as illustrated in a 2021 MFS report).
To combat this flucutuative nature of asset class performance, many experienced investors choose to devise portfolio diversification strategies that consider a number of well-performing asset classes.
This approach not only serves to mitigate potential risks from any one asset class’s failure (think the recent global cryptocurrency market crash), but has the ability to position investment portfolios favourably for future market exposure to growth - a strategy often manifested in the form of a balance in short and long term oriented investments.
Popularly illustrated in the form of a traditional “60:40 portfolio”, the theory behind this classical split is that 60% of the portfolio should be made up of stocks that target higher investment growth (often with a shorter term focus and naturally more risky nature) and the remaining 40% should be comprised of bonds that offer less volatile, long term growth to act as a cushion for any stock fluctuations.
Though this classic portfolio diversification strategy has proved staple for many investors over the years, some suggest the theory is outdated and that recent macroeconomic pressures and the rise of newer, more efficient alternative investments have surpassed it in effectiveness.
Though a range of both traditional and alternative investments can be included across a diversified investment portfolio, it can be useful to analyse a handful of the most effective for generating positive returns, significant impacts and powerful tax efficiencies accessibly.
High interest bonds
Recent fiscal pressures noticed throughout the UK - from the record inflation rates of 2.5% recorded in June 2021 to continued interest lows that have seen the BoE’s base rate remain at 0.1% for the 18th consecutive month - have put increasing pressure on investors’ portfolios this year, especially those that rely on a large proportion of low interest bonds in a 60:40 split.
With popular low interest bonds such as gilts and corporate bonds often targeting APRs below 1%, this means that in many cases capital held in such assets can - relative to inflation - be eroded over time.
According to a recent The Times piece, these stubborn economic pressures have been the root cause of many investors’ decisions to ditch traditional portfolio diversification strategies favouring low interest bonds - and instead opt for more flexible, higher interest options such as property bonds.
Though a host of bond types can be argued to be suitable alternatives to diminishing government bonds, the asset backed nature, tax efficient features (utilising a £20,000 tax free ISA allowance via the IFISA) and ability to transact on a less centralised basis via peer-to-peer (P2P) loans, are all features that have promoted the suitability of property bonds in a diversified portfolio in recent years especially.
Joint venture property investing
Following the recent rapid acceleration of the UK housing market that saw more than 700,000 house sales in progress in June 2021 (in what was the highest figure noticed in the past decade), diversifying into property has become an increasingly popular choice for experienced investors this year.
And where assets such as property bonds have often been targeted by investors seeking more gradual, incremental returns, joint venture property investing (JV) has been outlined as a high target growth alternative for investors looking to take advantage of the property market with potentially more aggressive returns.
A temporary, formalised partnership of builders, finance houses and developers that contract with one another over the development of a particular project, JVs - although possessing the notable risks associated with property development - can allow investors to negate the higher costs, barriers to entry and liabilities associated with traditional routes such as buy-to-let, and are often easily accessible via co-investment platforms.
Therefore, for experienced investors with ambitious growth goals and knowledge of potential risks, it’s no surprise that the JV route is playing a growing role in many a portfolio diversification strategy ahead of the UK’s forecasted 22.5% increase in average property price by 2025.
Venture capital investments
Traditionally, stocks have played a significant part in the average investor’s portfolio. A widely available asset class that has the potential to generate high growth in short periods of time whilst also offering a longer term, gradual growth focus when utilised through investment methods such as index funds, stocks have long been a global go-to when constructing a diversified portfolio.
But the high volatility associated with stocks (noticed especially recently due to turbulent global stock market conditions intensified over uncertainties surrounding the global economy) married with the rapid acceleration of the UK startup landscape in the first half of 2021 (recording almost double the £6.9 billion invested in the previous 6 months) has led many investors to reconsider the balance of stocks to venture capital investments in their portfolio.
With early stage investment consistently backed by government policy throughout 2021 so far, the emphasis on UK venture capital in investment portfolios has grown further.
Just last month the Prime Minister and Chancellor published an open letter addressed to the nation’s investors, urging them to “recognise the quality that other countries see in the UK” by “investing more money into the companies that will drive growth and prosperity across the UK”.
Investment schemes such as the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) have been highlighted as especially attractive routes for experienced investors looking to adapt their portfolio diversification strategy to be less reliant on stocks.
The schemes’ generous tax reliefs (including up to 50% income tax relief), key focuses on promising early stage companies and high target growth positions them as particularly attractive options for investors looking to minimise risk, maximise returns and generate positive social impacts amidst the recent UK startup surge.
Spread risk across a range of sectors
Though spreading risk across a host of asset classes is arguably the most important step to consider when building a robust, risk-balanced portfolio diversification strategy, diversifying investments across industries is another key factor to consider, especially when one asset class dominates an investor’s portfolio.
The key motive for this strategy is to ensure that, should an industry be hit by a significant downturn (such as the global airline travel industry, which has noticed global stock levels drop to less than half their prices 2019), an investor’s portfolio would not bear the full impact, but rather absorb the hit due to its spread of risk across sectors.
A 2017 Bloomberg analysis conducted on FTSE 100 stock index weightings over the previous decade gives further evidence to the importance of sector risk spreading in a portfolio diversification strategy.
Whilst the study revealed the three front-running industries in the index of finance, energy and consumer staples remained the same, differences such as a 36% decrease in the percentage weighting of the UK telecom industry from 2007-2017 suggested significant shifts in leading industries’ performances were still very possible.
Though case studies and industry data have long supported the merits of applying sector-by-sector risk allocation in an investor’s portfolio diversification strategy, this doesn’t necessarily mean an investor must distribute capital across distinctly opposing industries.
Should, for example, an investor wish to capitalise on multiple investments into the UK’s burgeoning tech sector whilst maintaining a diversified portfolio, this could still be achieved by distributing investments across a range of sub-sectors.
From data rich fintech platforms like Business Finance Market, to innovative threat intelligence providers such as Intelligence Fusion to touchless digital ordering specialists like Qikserve, investing across a range of sub sectors can be just as effective in spreading risk, especially when combined with tax efficient investments.
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Continually build on your portfolio
Whilst you may at present have an adequately diversified portfolio that includes an optimal range of asset classes spread across a host of industries and potentially even international economies, the key to retaining an effective portfolio diversification strategy is to continue building on it.
Using long term portfolio development techniques such as dollar-cost averaging (DCA), although not preferable for every investor, can allow investors to systematically invest equal amounts spaced over regular intervals over a prolonged period of time, and is just one strategy commonly used for future portfolio planning.
Effectively pre-empted allocation strategies like DCA suggest investors to smooth out the peaks and troughs associated with market volatility and avoid making the potential mistake of making one considerable investment that is poorly timed, rather aimings to give the investor more time to identify the optimal stage to invest.
Not only does continually building on your portfolio give you the opportunity to notice peak investment periods, but it allows the investor to identify shifts and trends from asset class to asset class. As illustrated previously on MFS’ ‘20 Years of the Best and Worst’ report, what is an ideally risk-balanced, growth focused portfolio now, may not be in five years time.
Regardless of experience, background or industry, decades of research and case studies suggest developing an effective portfolio diversification strategy that follows specific processes and makes use of established alternative investments can have decisive impacts on an investor’s performance, flexibility and durability throughout changing market backdrops.
And where it’s undeniable that investment portfolios based around a single asset - whether it be stock, crypto or property - have and will continue to witness success when implemented precisely, to maximise the potential of future returns, minimise the damage unforeseen circumstances can incur and discover an optimal balance of growth and impact within your future investment portfolio, diversification is key.