How diversified is your portfolio?
Unhelpful commentary
If you are tempted to forego exposure to government bonds, I believe you are in danger of reducing your portfolio’s diversification.
With yields close to 3% we’re reading more and more about an inevitable collapse in bond prices.
Some of the analysis is quite lazy.
Dangerously it encourages investors to replace government bonds with corporate bonds, absolute return funds or increased equity investment.
This is a misguided attempt to reduce risks.
Ordinarily this change would be intuitively wrong. With today’s narrative it is somehow deemed sensible.
Dodgy motives and logic?
The motives for these changes are riddled with inconsistencies and vulnerable to the risk of poor forecasting.
There’s an odd logic which suggests that simply because asset A is ‘unattractive’ asset B is automatically ‘attractive’.
More damaging though is the idea that a wholesale switch from government bonds can be exercised without reducing diversification.
What is diversification?
Diversification is most often linked with that tired cliché “don’t put all your eggs in one basket”.
Its perceived benefits are used to underwrite investor “demand” for exotic funds and investments.
All too often this results in reduced (or non-existent) regulation, liquidity, transparency and good governance. All of which massively increases risk of course.
Considered diversification is about so much more.
At the core of real attempts to diversify is the desire to reduce unnecessary risks.
Our non-exhaustive list includes regulatory risk, liquidity risk, transparency risk, governance risk, promoter risk etc. And that’s before you even get to the investment risks (inflation, interest rates etc.).
Real diversification requires a fuller understanding of how different asset classes behave and correlate as we move from one economic situation to the next.
Who’d be a forecaster?
It is in the nature of the economy and most human behaviour that they are very difficult to forecast accurately. Both often behave erratically and irrationally.
There are vast resources and research capability at the fingertips of the Bank of England, the Treasury, the Office for Budget Responsibility and countless investment banks, universities and other forecasting institutions.
Yet they still cannot accurately describe how the UK economy will look later this year.
Given the constant revisions to GDP, unemployment figures etc. it seems clear they can’t even accurately report was has happened.
How then can we expect anyone to accurately forecast, predict or even guess where we will be in 10 or 20 years’ time?
We can’t.
Where to start?
We start with including assets that we can expect to perform well in one, or more, of the following four economic conditions:
- high growth / low inflation
- high inflation / low growth
- high growth / high inflation
- low growth / low inflation or disinflation
In addition
To this we add periods of expected yet spontaneous panic (we count five stock market panics in just the last fifteen years).
Exposure to assets that perform well during times of crisis is a good thing.
Guess what?
UK government bonds (gilts) perform well in scenarios 1and 4. They also benefit from being increasingly attractive in times of stock market panic.
Index-linked gilts and overseas government bonds perform well in periods with higher domestic inflation with mixed performance in times of panic.
In foregoing exposure to government bonds, you would be shaping your portfolio for just 2 of the 4 potential economic environments highlighted above.
Corporate bonds are not the answer
In these instances corporate bonds are not a substitute for government bonds. They share some equity-like properties – lower corporate earnings can amount to higher bond defaults.
What is more, you would be increasing your portfolio’s sensitivity to falls during times of panic.
Given investors’ propensity to sell out of falling markets, this latter tendency is far more damaging in the long-run than you might think.
Final thoughts
We’re not so contrarian to think that returns from government bonds will be terrific going forward.
That is not our message.
Lowering exposure to government bonds may be appropriate for some investors – based on their individual circumstances.
However, if your starting point is a sensibly diversified portfolio, reducing government bonds only increases risks it does not reduce them.