Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 68

Diversification lessons from the GFC

In part 1 of this trilogy we reviewed the work of Harry Markowitz and William Sharpe, whose ideas shape our understanding of diversification, the foundation stone on which modern portfolio theory sits. In part 2, we look at risk in a diversified portfolio, and how well diversification performed in Australia during the Global Financial Crisis.

Diversification and superannuation governance

All Australian superannuation funds must adhere to the investment strategy operating standard embedded within legislation which (in part) states that the trustee of a super fund must:

“….formulate, review regularly and give effect to an investment strategy that has regard to…the risks involved…and the likely returns from…the entity’s investments, [as well as]….the composition of the entity’s investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification.”

The Markowitz/Sharpe language of expected (likely) returns, risk and diversification is explicitly included. As every superannuation trustee is legally obliged to meet the above operating standard, it applies equally to the 300-odd APRA regulated super funds as to some one million individuals who are trustee-members of SMSFs.

A 2007 government-funded financial literacy study found that whilst 55% of people considered potential returns when making financial decisions, only 34% considered risk and return together. More worryingly perhaps, only 5% considered diversification. How therefore should we assess our exposure to “risks from inadequate diversification”?

Diversification by capital and by risk

In the previous article investment diversification was illustrated with reference to a pie chart for the average default APRA-regulated superannuation option. The current average default option holds some 61% in property and equities, 22.5% in cash and fixed interest and 16.5% in alternatives strategies. The chart from Part 1 is reproduced below left.HC Chart1 270614

HC Chart1 270614

The chart on the right indicates how much each asset class contributes to total portfolio volatility (based on monthly data for the ten years ending December 2013). Australian equities, whilst comprising 26.5% of capital, contribute almost 36% to portfolio volatility. International equities and Australian property likewise add more to portfolio risk than their respective capital allocations. Alternative strategies, taken together, are the only growth-like asset class that contributes less to portfolio volatility than to capital allocation. [Editor’s note: The risk and volatilities contained within the alternatives asset class varies widely depending on what alternatives are used.]

In the average default super option today equities and property account for some 61% of capital, but more than 90% of portfolio volatility. To determine why, one first needs to understand the effect of asset co-movement.

Correlation – the key to diversification

The objective of intelligent diversification is to find investments that do not move together in response to the same stimulus, but will in aggregate provide a satisfactory return. Asset co-movements are generally measured either by covariance or correlation. A correlation coefficient is always bounded by -1.0 and +1.0. Risk is effectively nullified if a portfolio consists of two assets with a correlation of -1.0, similar to sound waves of equal but opposing amplitude. A correlation of +1.0 implies two assets with perfectly synchronous movement, providing no risk reduction benefit at all.

Harry Markowitz’s key insight was that if you could accurately forecast the return and risk of each security in a portfolio and their various correlations, you could create a diversified portfolio optimised between risk and return based on your risk tolerance. In determining what he called ‘relevant beliefs’, Markowitz suggested reviewing historical statistics and adjusting these for “factors or nuances not taken into account by the formal computations”. In other words, the best guess as to what might happen in the future is that which has occurred most frequently in the past, adjusted for any ‘relevant beliefs’ as to future market movements.

Taking the Markowitz approach, the following risk (standard deviation) and correlation statistics compare each asset class with the diversified default option portfolio shown in the above pie chart:HC Table1 270614

The statistics above reveal why the risk allocation chart differs so markedly from the asset allocation chart. In a portfolio where growth assets dominate, the high volatility of equities and property imposes an outsized influence on total portfolio risk; an influence that low volatility cash and bonds cannot overcome despite the risk dampening effect of their negative correlations.

All the above is wholly consistent with William Sharpe’s pricing model, which holds that higher risk must accompany higher expected returns in order for capital markets to clear. But what of diversification during the GFC? Did it fail when needed most?

Diversification and the GFC

Let’s examine the correlation of Australian equities to other asset classes below:HC Table2 270614

The movement of growth assets did indeed become more synchronous during the GFC. That Australian and global equity correlations increased in the midst of such a downturn should not have surprised. The increased correlation between Australian equities and Australian property was, at the time, less expected and was a result of listed property trusts (A-REITs) having become more equity-like in the years leading up to 2007.

Placing $10,000 in each of the following on 1 January 2008, generating index returns with no contributions, withdrawals, fees or taxes resulted in the following capital value changes by year’s end:HC Table3 270614

The above data dispels the notion that diversification’s protective qualities disappeared completely during the depths of the GFC. Whilst capital loss was greatest in equities and property, the diversified portfolio’s weighting to these assets was partially offset by strongly positive cash and fixed interest returns, and by lowly-correlated alternative asset strategies that fell only marginally by comparison. Rumours of diversification’s death during the GFC appear to have been greatly exaggerated.

Where to now for diversification?

Diversification works in theory and it appears to hold up in practice. Where it is found wanting is in the assumptions it makes of the average investor’s ability to form ‘relevant beliefs’ as to risk, returns and correlations. Here modern portfolio theory appears somewhat detached from human behavioural reality, as I commented in the Cuffelinks article: The Harry Markowitz Interview, Part 2: Retail financial advice.

The concluding article in this trilogy will incorporate aspects of investor behaviour by considering an alternative approach to diversification in retirement planning.

 

Harry Chemay is a Certified Investment Management Analyst who consults across both retail and institutional superannuation, focusing on post-retirement outcomes. He has previously practised as a specialist SMSF advisor, and as an investment consultant to APRA-regulated superannuation funds.

The author would like to acknowledge Matthew Drzewucki, Investment Analyst at Equipsuper, for his assistance in the analytical work involved in preparing this article.

The total portfolio volatility analysis was conducted using monthly index returns for the period January 2004 to December 2013. Risk allocation is the historic co-variation between each asset class and the total portfolio, expressed as a percentage of the aggregate variance of the portfolio.

The following indices were used as asset class returns: Australian equities – S&P/ASX 300; Australian property – 50% Mercer/IPD Australia Property Fund Index and 50% S&P/ASX 300 A-REIT; International equities – MSCI World (ex-Aust) net AUD unhedged; Australian fixed interest – UBS Australia composite bond index 0+ years; Global fixed interest – Citigroup world government bond index AUD hedged; Cash – UBS 90 day bank bill index 0+ years; Other – 33.33% Cambridge Associates Australian Private Equity & Venture Capital index, 33.33% MSCI world infrastructure net AUD unhedged, 33.33% HFRI hedge fund composite index gross AUD unhedged.

RELATED ARTICLES

The long and short of hedge funds, Part 2

The long and short of hedge funds, Part 1

Diversification: past, present and future

banner

Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Gullible travels, or are Aussies more sceptical?

Businesses exploit the psychological processes that people go through when they decide to buy something, but does the US research work when faced with "traditional hard-bitten, no-bullshit Australian scepticism"?

Retirement

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

Retirement

Global survey shows Australians least confident about retiring

Australians are generally optimistic about retiring comfortably but their confidence lags retirement savers in other countries. They are also the most unsure about future returns and withdrawal rates in retirement.

Financial planning

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Investment strategies

Morningstar asset class performance, 2021 and historical

As we enter a new year, we dive into the Morningstar database to see which asset classes have performed well over various time periods, with the related risks and largest historical drawdowns.

Investment strategies

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Using past performance is a risky way to invest

We often assign quality in investment choice by historical returns, backed up when we see fund flows directed towards such historically well-performing funds. This is a mistake made by investors and regulators.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.