De-Risking in Switzerland: Be First to Diversify Your Portfolio

There are many parallels between the 1920s and the 2020s. Both took off with a roar: stock markets across the globe reached peak valuation (both in terms of the nominal indices as well as P/E ratios) and unemployment hit record lows.   Companies then as now also enjoyed access to more capital at a lower rate than previous generations could’ve dreamed of.

But today, just as in the 1920s, investors’ long-held optimism has abruptly evaporated. After a bull rally in February that saw the S&P500 reach the highest ever level, it then fell off a cliff thanks to panic selling over the global impact of the coronavirus pandemic.

This year’s stock market crash was the biggest since the Great Recession and with most of the developed world placed under lockdown, the global economy has entered a downturn deeper than any other in living memory.

These events have placed portfolio risk management squarely at the centre of conversation across financial capitals. And with the word diversification now on the tip of the tongues of investment managers across the globe, early birds are jostling to ingest a magical tonic before gatecrashers try to enter the party.

What happens to a portfolio during a crisis?

A market correction is defined as a fall in nominal value of greater or equal to 10%. Classic advocates of portfolio diversification use the “not putting eggs in one basket” analogy to illustrate the importance of owning multiple stocks. The theory goes that if you own one stock and its value drops by 10% then your entire portfolio has just lost 10%. whereas if you own 2 stocks and one drops by 10% whilst the other only decreases 5%, then you are 2.5% better off than the mono-stock scenario.

In fact, the number of stocks in a portfolio, as well as their risk-return profile, has been mathematically modeled (Figure 1) and we can garner some useful insights:

• Portfolio volatility and return move in tandem -> the higher the return, the greater the volatility (i.e. risk)
• The number of stocks in a portfolio directly impacts the risk-return profile
• Once a threshold in stock number has been reached, increased diversification offers diminishing risk and return potentials

The phenomenon above can be observed across most portfolios. If you are holding an asset with variable value (i.e. bond, stocks, ETFs, REITs, properties), then you will experience this.

Figure 1. The impact of portfolio population on return and volatility
Source: JVB

Do you know the typical diversification mistakes?

Many modern investors deploy the diversification strategy without fully understanding its implication or the right way to implement it.

Issue 1:  Putting the eggs in multiple baskets, but all the baskets into a single car

The rational response to “don’t put all your eggs in one basket” would be to place your eggs in different baskets. Yet nobody seems to question where the baskets themselves are being placed. If these baskets are put into the boot of a single car and that car was involved in a crash, then being placed in different baskets would do the poor little eggs no good, since the baskets themselves would have been smashed.

Equally, investors would do well by questioning the underlying risk factors facing each asset they own, to ensure all risks are mitigated as much as possible by holding assets that share completely different risk profiles.

For example, if investing in financial stocks is your thing, it is no good to go out and own 10 different banking stocks, simply because if there is a systematic issue with the industry (like the 2007 Subprime Mortgage Crisis) then the entire industry would be impacted. Instead, it is far better to own some gold alongside your favourite banks, given that these two assets are uncorrelated (i.e. the movement of one has little effect on the movement of another). In fact, it has been documented that assets within similar classes share a 60% correlation (meaning that their nominal performance is 60% identical).

Consequently, the perception of diversification through owning multiple stocks often completely masks the underlying risk that remains within a portfolio. This can make investors complacent and the portfolio vulnerable to adverse market conditions.

“Don’t put all your eggs in one basket” is great,
but if you have multiple baskets,
where do you place those baskets themselves?

Issue 2:  If one always goes up when the other goes down, you get ... zero

The second issue with incorrect diversification is the adverse impact on the expected return. As Figure 1 has clearly demonstrated, increasing the stock population drastically reduces portfolio volatility but also trims the expected return simultaneously. This isn’t entirely surprising because investors often perceive diversification as packing in a series of negatively correlated assets (i.e. their pricings move in different directions under the same circumstances). Imagine if your portfolio had 2 companies: one making umbrellas and the other making sunglasses. On a rainy day, the umbrella stock rises whilst the sunglass stock falls and the opposite happens on a sunny day. Over the course of the year (and assuming no cloudy days!), your portfolio will see little increase because no matter the weather, the rise of one will ensure the fall of the other, given the two are negatively correlated.