How to make your portfolio work for all seasons

Jupiter Strategic Total Return fund manager Miles Geldard says multi-asset investing with an emphasis on risk budgeting is the logical development of portfolio diversification.

Diversification for protection is an old idea. Around 2,000 years ago the Talmud recommended dividing money into three parts and investing a third in land, a third in business and keeping a third in reserve.

This early example of a balanced portfolio is remarkably modern in conception because it emphasises that the diversification of risk should take precedence over the maximisation of return.

Diversification by number

Let us begin with one asset class. In 1977, the Journal of Business published a paper by Elton and Gruber. They used 3,290 shares to randomly create equal sized portfolios ranging from 1-1,000 constituents. The typical annual standard deviation of a one-share portfolio was 50% whereas a portfolio of 20 shares reduced this to 21%. Thereafter, the reduction in risk faded fast.

Random portfolios with 1,000 shares only reduced the annual standard deviation to 19%. This additional small gain might not merit the extra transaction costs involved for small portfolios.

In 2003, a study by Professor Gordon Tang suggested a portfolio size of 20 was required to eliminate 95% of the diversifiable risk on average without sacrificing the expected return. The addition of 80 stocks (i.e. a portfolio of 100) was required to eliminate an extra 4% (i.e. 99% total) of diversifiable risk.

Unfortunately, diversification by number cannot remove risk entirely. Systemic risk – the risk inherent in the entire equity market – cannot be eliminated since, for example, an unexpected increase in interest rates could raise discounting and borrowing costs and have a negative effect on almost all shares/companies.

Diversification by asset class

The next step is to consider a portfolio of two asset classes, typically equities and bonds. The aim of such strategic asset allocation is to create an asset mix that provides the optimal balance between expected risk and return for the long-term investor.

As early as 1949, in his book The Intelligent Investor, Benjamin Graham recommended that defensive investors maintained a 50-50 division between equities and bonds, and periodically rebalance their portfolios. Importantly, this restrained investors from being overexposed to equities should they rise to dangerous heights.

In the years that followed, academics developed the concept of using numerous asset classes to provide the best risk-adjusted returns. In the 1950s, Harry Markowitz developed Modern Portfolio Theory, a form of diversification which proposes that: risk actually drives return rather than being merely an unfortunate by-product of the search for higher returns; the portfolio dominates its constituent assets; and the way to minimise risk for a given level of expected return is to minimise the covariance of returns from the assets within a portfolio.

This theory led to the development of Value-at-Risk (VaR), which attempted to answer the question: “How much can I lose?” After the collapse of Long Term Capital Management in 1998, VaR became the established measure of risk control among financial institutions.

While Modern Portfolio Theory has been highly influential among financial institutions, less attention has been paid to the questionable assumptions that underpin it. The first assumption is that correlations between different assets remain fixed and invariable. Second, that standard deviation of return is an all-encompassing proxy for risk. Third, that the investment returns are themselves normally distributed. Fourth, that investors are always rational and risk-averse. Fifth, that investors’ actions do not influence prices.