Investment Strategy

Diversification and correlation go hand in hand

By AMP Capital

What would you do if most of your investments fell in tandem? What if this happened when you were about to retire? Diversification can mitigate this risk, however achieving true diversification requires an understanding of correlation.

Are you really diversified enough? That’s the question more SMSF investors should be asking themselves after a recent AMP Capital survey* found about half had investment portfolios that were less diversified than they thought.

This is despite 41 percent of those surveyed citing diversification as their biggest SMSF concern.

Nearly half were investing under the premise that a portfolio of 20 individual stocks is diversified, indicating the assumption that this would give them enough spread of risk to protect themselves. This is often false though, as most stocks are usually hit in tandem when markets fall.

Case in point was the example earlier this year when Australian shares slumped on the back of the Dow Jones suffering a record intra-day drop, which in turn was based on fears of inflation rising.

Those 65 and over would be particularly impacted in situations where stock markets fall, as the survey showed that people in this age group had about one-third of their portfolio invested in direct shares.

Most of those stocks have now recovered, plus some. The point remains the same though. This would have been a scary time for people about to retire or already in retirement if a substantial portion of their SMSF was invested in Australian equities - even if it spread across different sectors. This is called sequencing risk - the risk of an investment performing poorly at precisely the wrong time, which is heightened when a portfolio is not truly diversified. Learn more about sequencing risk in a recent article by Graeme Colley here.

Don’t correlate

The key to being diversified is to make sure there is very little correlation, or even negative correlation, between your investments.

While that sounds obvious, in reality, it is less so. For instance, if your SMSF is invested in equities in Australia and the US, that might sound diversified. But actually, regardless of the individual performance of Australian listed companies, our market is highly correlated with the US.

In fact, many developed economies are highly correlated with the performance of the Dow Jones. Having a portfolio that consists largely of US and Australian stocks won’t provide true diversification benefits.

Investments are correlated when they move in the same direction at the same time. A safe retirement investor will try to avoid this scenario by investing in real assets like property and infrastructure as well as equities, cash, and fixed interest, across the risk spectrum.

A combination of listed and unlisted investments is also important to reduce the overall correlation of your portfolio. Unlike listed investments, valuations of unlisted investments are less likely to move up or down dramatically based on market conditions as they are not traded on public markets. Importantly, valuations of listed and unlisted assets tend not to move together – meaning they are less correlated.

The GFC’s lasting impact

Before the Global Financial Crisis (GFC) being invested in shares and bonds seemed a good way to diversify as these two asset classes had shown little correlation. When share prices went up, bond prices used to fall and vice versa.

That theory came dramatically unstuck during the GFC, when banks stopped lending to one another and global markets were under so much pressure that both equities and bonds fell.

Gold and shares are often negatively correlated, however during the GFC, gold prices fell along with equity markets, but this was quickly reversed. During the 18-month stockmarket rout, the price of gold rose 25 per cent.

The breakdown of historical correlations since the GFC means that true diversification is more important than ever.

How to spread risk

The best way to ensure your SMSF is truly diversified is to consider what it is invested in, and then specify whether the same negative event would have a similar impact across your investments.

While equity investments can offer high potential returns, they should be mixed with investments that offer lower risk and therefore usually lower returns.

For example, when the GFC hit, investments in community infrastructure assets such as hospitals and schools provided a defensive strategy due to their stable long-term cash flows. Likewise, direct property investments would have suffered less than listed ones during this time.

A truly diversified SMSF should include all the major asset classes including cash, fixed interest, local shares, and international shares, as well as real assets like property and infrastructure, encompassing both unlisted and listed investments spread across the risk spectrum.

To ensure your portfolio is truly diversified and protect yourself against risk, it may be worth taking the time to look closely at your SMSF strategy and make sure you have a broad spread of investments that do not all correlate.

* Based on responses of 679 SMSF investors surveyed in December 2017

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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