When recently asked about the investment advice he would give his younger self, Greg Davis, CIO of Vanguard, said it “would be to [better] understand diversification and the importance of it.” After all, diversification intrinsically limits a portfolio’s risk and helps an investor generate more stable returns.
Investors have a few options to create a diversified portfolio. In both equity and debt markets, investors can create diversification by investing in sectors that have minimal overlap, seek deals with geographic diversity and pursue different verticals of both private and public equity and debt, including venture opportunities.
“The reality is: When I first started investing, the idea was to buy the best stock that you thought had a lot of potential that would generate outsized returns,” Davis continued in an answer posted on Vanguard’s website. “But the reality is: Putting all your chips on one stock is a very dangerous way to invest, and it’s not really investing—it’s speculating.”.
In 2022, the 60/40 portfolio and the diversification expected from the relationship between fixed income and equities failed to provide safety, as stocks and bonds became correlated and both asset classes had negative returns. Asset managers are now offering cash flows and yields from other, more esoteric investment offerings.
“Alternative strategies, such as those focused on hedge funds, private capital and real assets, have long been appealing as a potential source of higher yields, lower volatility and returns uncorrelated with stocks and bonds,” wrote Daniel Maccarrone, co-head of global investment manager analysis at Morgan Stanley, in wealth management research released by the firm.
Maccarrone’s research showed that adding alternative exposure to a portfolio may reduce volatility and potentially increase returns. Alternatives investing primarily in hedge funds, private debt and real assets are less likely to be volatile because those asset classes can be less subject to the fluctuation of interest rates.
Data from January 1, 1990, through December 31, 2021, show that a portfolio that was 40% stocks, 40% bonds and 20% alternatives experienced 88 basis points less difference in annual portfolio volatility than a 50% stock, 50% bond portfolio split, while outperforming the 50-50 portfolio by 45 basis points annually in returns.
Alternative strategies, such as fund of funds, non-traded REITs and interval funds, that were routinely reserved for institutional investors are becoming more accessible to high-net-worth retail investors, according to Morgan Stanley. Though these strategies were most likely not available to Davis when he was a younger investor still figuring out the gravity of diversification, they might find a role in providing diversification for investors as the rules of investing become more democratized in the future. Diversification, as Davis said, “is critically, critically important.”
Looking forward to 2023, it remains to be seen if the Fed will pivot and stop raising or start cutting interest rates, which could thwart the recent correlation of stocks and bonds.
In the meantime, alternatives manager KKR is promoting an allocation of 40% stocks, 30% bonds and 30% alternatives that “offers more robustness around diversification, and inflation protection for the macroeconomic environment ahead.”
Similar conclusions from KKR, Morgan Stanley and other market participants recommending greater diversification exists outside the traditional 60/40 portfolio and advocating an allocation to alternatives suggests exactly what Davis advocated to his younger self: Investors can always better understand diversification, recognize the importance of it, and explore strategies to increase it within their portfolios.