AXA Investment Managers’ Richard Marwood says understanding how asset classes react differently to various market conditions is the key to real portfolio diversification.

In a world where all investment decisions were perfect, there would be no such thing as multi-asset class investing. Our perfect investors, with their 100% foresight, would simply put all of their money into the asset class they knew was going to perform the best and that would be that.

However, as we know, the world is not like that – far from it – and even the shrewdest investor does not get everything correct, all of the time. This is where diversification, a cornerstone of modern portfolio theory, steps in.

Through holding a varied mix of assets an investor will, in theory, always have exposure to some winners in their portfolio – the good offsetting the bad – thereby diversifying overall risk. Accordingly, this multi-asset investment approach offers the potential for ‘smoother’ long-term investment returns, whatever the prevailing market conditions.

Balancing correlation

However, simply holding a range of different assets does not necessarily mean you have a diversified portfolio. True diversification is built around the knowledge that asset classes react differently to various market conditions and perform with varying levels of correlation.

Efficient multi-asset investing places particular emphasis on achieving low performance correlation, or even to some extent, inverse correlation between assets. The aim is to optimise the balance between performance and risk.

The notion of what constitutes a truly diversified portfolio is very important, given that many multi-asset funds that claim high diversification, are in fact, anything but. A portfolio may hold several different asset classes for example, and the investor may think they are well-diversified, but if these asset classes are highly correlated and react similarly to certain market conditions, not only is the diversification impact minimal, but the risk exposure is potentially magnified.

Choosing the right mix of assets, in the right proportions, is the key task of a multi-asset manager. Generally, it is the asset allocation within a fund – not the choice of securities within an asset class – that has the largest impact on long-term performance.

Asset classes tend to be placed along a spectrum of perceived risk, typically with equities at the riskier end of this range and cash and government bonds at the opposite end.