Diversification plays an important role in mitigating risk in a bear market

This phenomenon occurs as a result of the benefits of diversification reducing during periods of market stress which, in essence, results in portfolios being exposed to a single factor driving the overall market.

 

During normal market activity, investors enjoy the ‘free lunch’ called diversification. But in the event of market extremes, as experienced during 2008, this effect is reduced as risky assets tend to move in the same direction.

Does this mean then that diversification has failed us? On the contrary, investors should realise that they are inherently investing in risky assets, which implies taking on risk, and that it is important to stay invested over longer time horizons and diversify between stocks and asset classes in order to reap associated benefits.

Diversifying between asset classes becomes important as more than 90% of the variability of returns can be explained by the combination of asset classes within a portfolio. Asset classes tend to behave differently in varying market environments. For example, inflationary environments are more suited to commodities and property, while expansionary economic environments favour equities. Timing asset allocation switches is a dynamic process, which in itself is not trivial, although the market does provide signals which indicate when sentiment is changing.

 

For this reason, the ‘error’ that needs to be avoided is a large drawdown as the return required to restore the portfolio to the before-loss level is much larger than the drawdown itself. This effect exacerbates the larger the initial drawdown. For example, suppose that the portfolio had suffered an initial loss of 50%, the portfolio would need to return 100% in order to recover to the before-loss level, which implies that the current portfolio needs to double.

However, if the initial loss was two-thirds, the portfolio would need to triple in order to recover the initial loss. This is where the benefit of compound interest, often referred to as the eighth wonder of the world, comes into play.

 

For example, compare investors A and B. Suppose that investor A chose to invest R100 in an equity-only portfolio five years ago. His portfolio would be worth R171.50 as at the end of January 2013. Had investor B chosen to gain exposure to equity and bonds in a 60:40 equity to bond split at the same time as investor A, investor B’s portfolio would be worth R174.23 at the end of the investment period based on monthly rebalancing.

 

Investor B’s returns have outperformed investor A’s, despite the fact that equities have rallied more than 144.35% since the market bottom in February 2009 (compared to 103.68% for the balanced portfolio). As mentioned previously, the initial drawdown played an important role in the outcome of the two investments. Equity suffered an initial drawdown of 40.44%, whereas the balanced portfolio only decreased by 21.24%. The larger drawdown in the equity portfolio has continued to be a drag on portfolio performance, whereas the effect of compounding aided the balanced portfolio, which suffered a smaller initial reduction in the portfolio value.

 

Managing downside risk, or investment return losses, then becomes the next consideration. Reducing downside in the long term is achieved by diversifying wisely between sources of return that perform at different times in the market cycle. However, as we know from 2008, diversification does not necessarily help in the short to medium term.

Diversification, alongside asset allocation, is clearly important within a bear market. Understanding the sources of risk and employing portfolio construction techniques that reduce the possibility of large drawdowns go hand-in-hand with this approach.