Diversification is not just an academic nicety but a core tenet of investing. It is also completely misunderstood. Most believe that diversification is about holding different investments in a portfolio. Well, you start with that, but it doesn’t end there.
Howard Marks describes it more aptly. “Intelligent diversification means not just investing in a bunch of different things, but in things that respond differently to the same factors. In a well-diversified portfolio, something that negatively influences investment A might have a positive and offsetting influence on investment B.”
This variability in response not only benefits the portfolio, but also the investor.
A diversified portfolio need not be a robust portfolio.
MARTA NORTON, chief investment officer for the Americas, Morningstar Investment Management
Think about your portfolio and the different environments that you can be in: high economic growth, low economic growth, high inflation, low inflation. If your entire portfolio depends on high economic growth and low inflation, then you don't have a robust portfolio.
Think about those different ranges of environments even within a single asset class. Within equities you can ask, "Which of these sectors is going to benefit in which environment?" For example, if we enter into a recession, financials are not a great place to be. If we don't hit a recession and rates are much higher, then there is something of a tailwind for financials. If we have a recession, maybe energy doesn't do so well. But if you have inflation, maybe energy does do well.
Get the picture? You may be buying a business that is modestly cheap but would actually do really well in a particular environment.
Your portfolio should not be tied to one single narrative.
DAN KEMP, chief investment officer for EMEA, Morningstar Investment Management
Diversification is not about the number of assets, but how they will behave in response to events. It's about making sure that you have some assets that will perform well in a recessionary environment, other assets that will perform well in inflationary environment.
Your portfolio should not be tied to one single narrative. While we don’t know what the future holds, we do know that having a sound framework for investing can help investors avoid mistakes during turbulent market conditions. This, in turn, can provide access to the benefits of compound returns. Focus less on maximizing returns today and more on building robust portfolios to reach your goals.
By ensuring that the portfolio is less vulnerable to a single economic or market outcome, an effectively diversified portfolio should also deliver fewer surprises for investors.
Look at revenue exposure
BEN JOHNSON, head of client solutions, asset management, Morningstar
When we choose a category that gives good diversification, we must consider another element: revenue exposure.
As companies continue to expand their global footprint, traditional means of measuring geographic diversification are increasingly insufficient. Measuring global diversification along dimensions of fundamental exposures - such as revenue - can paint a more complete picture of funds' degree of diversification.
Small-cap stocks tend to sell more in their home markets, while large caps make more sales away from home. Favouring small caps may then provide more direct exposure to local market fundamentals.
Some sectors are globetrotters, while others are homebodies. Financials, utilities, and real estate stocks typically have local asset bases and clientele and will tend to be most sensitive to fluctuations in local interest rates. Technology stocks have a more global reach.
Relying solely on historical correlations can be risky or even misleading.
NICOLO BRAGAZZA, senior investment analyst, Morningstar Investment Management
The correlation is an 'average' and does not tell us much about the behaviour of asset classes during certain market phases. In times of recession, the correlation between stocks and bonds has been positive by 0.09 points. In phases of high inflation (above 5%) it even rose to +0.23.
Diversification isn't solely about how far two asset classes move in different directions. Look for "diversifying fundamentals," rather than just “negative correlations" alone. For example, the correlations between the industrial sectors were all positive in 2022, but, unlike the others, the energy sector had positive returns. Having the energy sector in your portfolio would have provided one of the best diversifications in 2022.
The same applies to the U.S. dollar: it is true that Treasuries have fallen in the last year, but the USD has appreciated greatly due to the differences in the ways and times of monetary policies between the Federal Reserve and the other main central banks.
Also, 2022 is an example of a year where more assets in the portfolio would not have offered more diversification. The only asset classes that have delivered positive returns are the energy sector, the US dollar and some 'niche' markets such as Brazilian equities.
Larissa Fernand is an Investment Specialist and Senior Editor for Morningstar India. You can follow her on Twitter.