Diversification premium is an investment cure for coronavirus
Markets are walking on eggshells as the outbreak of the coronavirus Covid-19 wreaks economic havoc. Consensus figures for China’s economic growth have now been revised down from 6.1% in 2019 to 4.5% in 2020, but the effect of the virus extends far beyond that country.
Widespread travel shutdowns have severely affected air travel volumes, while hospitality chains, luxury-goods makers and retailers have come under pressure as consumers stay away from the shops and travellers put off holiday plans.
Global supply chains are also experiencing the effects as Chinese factories remain closed, leading Jaguar Land Rover to warn that its UK-based factories could run out of car parts, and Apple to warn of possible iPhone shortages.
Capital markets have responded to this bad news by selling down equities and commodities and buying safe-haven assets. Within a few days in February the MSCI all-country world index dropped 7.5% and the gold price lifted 8.5% to a five-year high.
These reactions suggest Covid-19 was unanticipated by the investment community. The world of investing is filled with such risks and uncertainties. The effect of the virus underlines the importance of managing risk as a first principle in any investment decision.
Rather than simply “buy the dips” or “sell based on strict stop-loss limits”, evidence suggests that a more nuanced approach is needed for successful risk management. The investment tool that immediately presents itself here is powerful, elegant and available to all investors: diversification.
Diversification is often misunderstood and mistreated. As we are witnessing, in times of heightened anxiety and uncertainty investors will often favour a “safe asset” that gives “a stable 5% return”. To get this steady return, investors will sell out of other riskier asset classes such as real estate and equities, which have less knowable returns.
With enough time the compound growth of the higher-returning investments more than make up for the lower-returning investments of cash and precious metals
But selling everything “risky” in times of stress to crowd into a “safe asset” such as cash or treasuries may not be as rational as it first seems — especially if the investment timeline is long. Imagine you find a stable, single asset investment that will provide a guaranteed 5% per annum over the next 25 years. If you invested R500,000 today, it would be worth nearly R1.7m at the end of the term.
If you shunned “the safe asset” and instead stuck with a portfolio of multiple assets — say some cash, gold, government bonds, real estate and equities — that together also gave you an average 5% per annum, you could end up with a substantially higher investment balance after 25 years. Jeffrey Levine, writing in Forbes, refers to this as the “diversification premium”.
But how could a multi-asset portfolio offering the same return of 5% per annum produce a bigger investment result? Imagine a new, diversified, multi-asset portfolio with the five asset classes mentioned, and assume “typical” returns for the asset classes as depicted below, and give them 25 years to work together. Here enters the diversification premium.
This second diversified portfolio will finish the 25 years with a net worth of R2.3m — 36% higher than the “stable 5%” portfolio. This is because with enough time the compound growth of the higher-returning investments — real estate and equities in the diversified portfolio — more than make up for the lower-returning investments of cash and precious metals. This results in a progressively higher average weighted return for the second portfolio, culminating in a total weighted return of about 7.5% by year 25.
in the real world of Covid-19, trade wars, Brexit and load-shedding, returns won’t have the same shape as the hypothetical portfolios given here. And in some cases the premium may not be worth pursuing — if you are just a few years from retirement, or if you cannot afford the risk of near-term volatility. While these examples show investments growing over time — as we would expect, otherwise why bother investing — there are no guarantees.
One of the asset classes making up the diversified portfolio could fall over 25 years (such as with Japanese equities), or it could be that all of them, except the safe asset, fall together for some time in a synchronised drawdown (seen in the global financial crisis). However, if the long-term goal is to grow your investment, there is a real, and often sizeable, “diversification premium” that can be achieved through proper portfolio construction.
The next time a crisis hits and you feel tempted to “run for cover” or buy a “safe 5%”, remember that not all 5% returns are equal. Investing is not about avoiding risk but about managing risk, and diversification is one of the most powerful tools available to manage risk and own returns.
• Saville is Cannon Asset Managers CEO.