Silver lining for non-diversified investors

In my role as CIO, I get to meet different kinds of investors. There are those with diversified portfolios of course, but many clients I speak to have a very clear bias towards one asset class: either equities or bonds. The biggest challenge for investors of all stripes this year is that there have been few places to hide. Global equities have fallen almost 20%, while the ramp up in interest rate hike expectations has also hit bond markets hard. Gold offered some respite for the first couple of months, but the precious metal has fallen 10% from those highs. The good news is that the simultaneous decline in asset classes could be a silver lining for investors when it comes to planning the next course.

What we saw this year is rare. Normally, high quality bonds appreciate in value if equities fall sharply. Equities usually fall at a time when people are becoming more concerned about slowing economic growth, which usually encourages central banks to ease monetary policy, which in turn pulls bond yields lower (and bond prices higher). Meanwhile, when bond prices are falling (ie. bond yields are rising), investors are normally becoming more positive on the outlook for growth, which is positive for corporate earnings growth and equity prices.

In one way, this inverse relationship between stocks and bonds is positive for investors as it means that losses in one part of the portfolio are offset, at least to some degree, by gains elsewhere in the portfolio. Indeed, this is the very reason why we recommend a diversified portfolio – diversification enables investors to smooth the performance of their investment and reduce the risks of being consumed by the urge to sell at exactly the wrong time.

However, for investors with concentration in the ‘wrong’ asset class, this divergent performance can be very painful. Not only would they have lost more money than they would have done if they had a diversified portfolio, but the cost of remedial action (ie. diversification) would have increased as the other asset classes would have appreciated in value. If diversification requires selling current holdings (assuming there is no cash on the sidelines to invest), the cost will be even greater because the investor will get less for the asset being sold (relative to history) and will pay more for the asset being acquired.

So why is this time different? To answer this question, we need to look at why equities and bonds have both fallen in value this year. The one-word answer: inflation! This time, the major concern is that high inflation will force central banks to tighten monetary policy to such a degree that it will choke off economic growth. Bond investors dislike inflation and higher interest rates. Meanwhile, equity investors abhor recessions. This has resulted in equity and bond prices falling in tandem this year.

The good news is that central banks might be winning the war against inflation, with inflation expectations showing tentative signs of peaking. So, what should investors with high concentration in a particular asset class do? They should use the opportunity to diversify into other asset classes. For sure, the investor will have to recognise some loss as s/he sells some assets to reduce concentration, but the good news is that the asset being acquired is also on sale and therefore the cost of the ‘medicine’ to fix the imbalanced portfolio is now much lower.

Of course, those who have been overweight in cash this year are in the best position, assuming they have not been in that position for too long. With equities and bonds both going ‘on sale’, this is a great opportunity to at least start increasing allocations to a diversified portfolio. This does not need to be confined to traditional asset classes, such as listed bonds and equities. The allocations could also include private assets, for instance private credit and private real estate. While cash has held its value in nominal terms, in real terms it has lost value to inflation for many years, especially this year.  

Therefore, while it is easy to focus on the empty half of your glass as an investor these days, for those who have learnt the hard way that they should change their investment approach, they should take comfort that the cost of doing so is much lower than it would normally be. It would be a real shame if investors failed to seize this opportunity to own a more diversified and balanced portfolio - starting today.

(Steve Brice is Chief Investment Officer at Standard Chartered Bank’s Wealth Management unit.)