Diversification as a key feature of investment strategies
The decision, in March 2020, by the state of Saudi Arabia to increase its production of oil, stunned the market. Almost immediately all the stock exchanges globally saw their main equity index go down significantly at a time when the market was already under pressure due to the Covid-19 crisis. In the backdrop of a general decline, the most impacted stocks were the companies active in the oil sector, whether they were some of the largest in the world, medium size oil-related businesses or smaller alternative oil producers.
This change in value of an entire segment of the market was a good reminder of one of the key principles of thoughtful investment: diversification. Arising from portfolio theory, diversification comes from a very simple idea, familiar to everyone:
“don’t put all your eggs in the same basket”
Every type of investment has risk attached to it. This risk and the perception of this risk can evolve over time, but it exists. Risk is something an investor should always consider.
Diversification is a proven and efficient way to manage investment risks. Diversification aims at spreading investments across a variety of asset classes, like equity, fixed income, real estate, unlisted assets, but also across a variety of risk concentration, like geographic or sectors. Furthermore, diversification helps smooth portfolio returns over time: as one investment increases, it offsets losses from another investment, thereby providing more regular returns on investment under various economic and market conditions.
However, diversification is not that simple to implement. The plethora of investment options available to an investor, able to invest across multiple asset classes and across multiple geographies, has enhanced the options for diversification but also made things much more complex.
The underlying risks of each asset class in each sector and each geography can be quite different on the face of it. However, a deeper analysis can unveil correlations amongst asset classes and amongst assets that could invalidate the benefit of a diversification strategy against specific risks. A simple example is the correlation between equity and fixed income risks: when equity risks increase significantly in a high-leverage environment, the equity risk will show significant correlation with the fixed income risk. In such a case, a portfolio investment strategy that appears facially diversified across asset class, could end up being inefficient or even have a negative impact for the portfolio.
This complexity and the need to assess the underlying risk of each asset class in each sector and each geography are what has made specialist portfolio managers and investment advisors so important, especially for families and entrepreneurs aiming at delivering solid returns over time with a long-term investment horizon.
Some of the most successful and wealthiest families have set-up dedicated family offices whose main objective is to interact with the professional investors globally to design customized investment strategies aiming at really benefiting from diversification. Similarly, private banks have developed for decades an offer to co-construct with clients truly diversified investment portfolios based on the client’s risk appetite on a transparent basis.
Matching a client’s investment horizon and risk appetite with a deep analysis of the underlying risks behind an investment is the very heart of a wealth manager’s added value. This expertise, this systematic approach to understanding risks and the ability to seek investment opportunities using a large network of relationships and expertise on behalf of our clients, whether on an advisory basis or on a delegated / discretionary basis, has been the hallmark of BNP Paribas Wealth Management since its creation over a century ago.
We passionately believe in diversification as a core feature of portfolio construction and wealth management. And the recent events have again reinforced this conviction.