Portfolio diversification

Portfolio diversification is one of the most commonly used labels in the world of finance. However, most of the times it is also misappropriated. Diversification is only achieved through the combination of non or negatively correlated assets. Regarding these, there are essentially five main asset classes: Equities (meaning passive investments in a group of individual stocks or mutual funds benchmarked to a mature equity index), Bonds (specifically Sovereign debt, not corporate bonds) and Liquidity (Deposits and Money Market funds), Real Estate, Absolute Return (Hedge Funds and Managed Accounts) and Private Equity funds.

In theory, one could imagine that with five different asset classes it would be pretty easy to achieve a diversified portfolio. Unfortunately, in the real world, negative correlation between asset classes is very rare. Therefore, the time element associated to the diversified investment plan is what in fact leads to superior rates of return. Below, you will find the historical correlation coefficients, calculated by Yale University, that effectively exist between them:

Equities/Bonds/Absolute Return/Private Equity/Real Estate/Liquidity

Equities 1.00
Bonds 0.06/1.00
Absolute Return 0.28/0.15/1.00
Private Equity 0.30/-0.17/ 0.29/1.00
Real Estate 0.13/0.03/0.06/0.08/1.00
Liquidity -0.09/0.70/-0.08/0.01/0.35/1.00

(Source: "Pioneering Portfolio Management", David Swensen, Yale University)

Hence, almost all asset classes exhibit positive correlation among themselves. And according to Yale these positive correlations tend to increase during market turmoil.

However, although market turmoil is possible, and eventually it does happen as we are witnessing now, it certainly is not the usual and most likely market outcome. That's why in the long run a portfolio based upon a high concentration in Bonds and Liquidity will not outperform another portfolio composed of riskier and more volatile assets. Because in the long run rates of return associated to equities, real estate, absolute return and private equity are higher than those expected from bonds and liquidity. Below, you will find the historical annual real rates of return associated to each asset class calculated by Yale:

Equities: 9%

Bonds: 1%

Liquidity: 0%

Real Estate: 4%

Absolute Return: 18%

Private Equity: 19%

(Source. "Pioneering Portfolio Management", David Swensen, Yale University)

Equities, Absolute Return and Private Equity are the main thrust behind positive performance. There is one caveat though. The performance statistics attributed to Absolute Return and Private Equity managers are contaminated by the so called Survivorship Bias since failed managers are excluded from the final average. That is why Yale has revised lower the expected annual real rate of return in these two fields by almost half compared to the historical readings.

The previous performance statistics also confirm that after a number of years Bonds and Liquidity are poor partners. Which leads me to the crucial point: in order to benefit from the inherent risk and return characteristics of each asset class, the investor has to be willing to stick with them for a period of several years. Of course, on any given year you may be penalized for having too much exposure to Equities or Bonds, but if you follow adequate diversification guidelines over 10 or 15 years it will pay off significantly.

Unfortunately, adhering to an investment guideline for 10 or 15 years is not easy. Most people tend to permanently adjust their tactics. That is not investing. That is speculating, and should be done only by professional traders or analysts. Common investors should stick to an investment plan. Below, you will find Yale's recommended long term portfolio as well as the average portfolio diversification that currently exists in my home country Portugal.

Yale/Portugal

Equities: 27%/7%

Bonds and Liquidity: 4%/47%

Real Estate: 27%/33%

Absolute Return: 25%/8%

Private Equity: 17%/5%

(Sources: Yale University, APFIPP, APCRI)

In Portugal, we exhibit an extraordinary aversion to risk. It is the consequence of poor financial literacy within the population and also results from an extremely closed and protected banking system that colludes against smaller operators. It has served us well in the past year. But will we benefit from it after a period of years? I believe not.

A final note: at PEDRO ARROJA we operate Managed Accounts with an Absolute Return mandate.