In troubled times, the benefits of portfolio diversification can be boosted by taking a fresh look at the drivers of resilience, as the following five charts illustrate.
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Diversification is the foremost driver of a portfolio’s resilience, but there is more to achieving this than random asset selection. All historical relationships can break down, so investors must constantly question and reassess them.
Figures 1a and 1b show correlations between different assets. The first chart shows correlations over the 12 months to January 3, what could be classified as a ‘normal’ market environment; the second shows correlations for the 12 months to April 15, which includes the period of high market stress linked to COVID-19.
In the first chart, where concerns over a global pandemic were absent, the cooler colours show many assets behaved differently from each other, providing a good level of diversification. By contrast, the second chart shows a level of market stress. Most assets started behaving in the same way, as evidenced by the prevalence of red, stripping portfolios of their protection. However, a few safe havens could still be found (such as government bonds), and portfolios allocated across such assets would have been more resilient.
Figure 1a: 52-week correlations as of January 3, 2020
Figure 1b: 52-week correlations as of April 15, 2020
ESG as a risk mitigator
During the global financial crisis of 2007-2009, when many correlations went to one as asset prices moved in lockstep, environmental, social and governance (ESG) factors proved among the best sources of resilience. A Bank of America Merrill Lynch study published in September 2019 found that “15 out of 17 bankruptcies in the S&P 500 between 2005 and 2015 afflicted companies with poor environmental and social scores five years prior to the bankruptcies”.1
In fact, with the world more connected than ever and risks becoming increasingly complex, the power of ESG integration as a risk management tool has grown significantly. The vast majority of key risks listed in the World Economic Forum’s Global Risks 2020 report (as shown in Figure 2) are linked to environmental issues, social disruption or governance failures.2 Even more importantly, many of these are interlinked, and the materialisation of one risk could have unintended and unpredictable knock-on effects elsewhere.
Figure 2: The Global Risks Interconnections Map 2020 – World Economic Forum
Allocating capital to companies with sound ESG credentials and encouraging the adoption of best practice through shareholder engagement can help make portfolios more resilient, particularly for longer-term investors.
Hubris versus humility
The current crisis has sparked a debate among financial market participants on the wisdom of “just in time” versus “just in case”. As the Financial Times recently noted: “Adequate preparedness demands wider margins and buffers. It also requires a tolerance for slack that goes against the grain of what, pre-Covid-19, was orthodox management thinking.”3
Professor John Kay, who recently co-authored Radical Uncertainty: Decision Making for an Unknowable Future with former Bank of England governor Mervyn King, explains that investors trying to protect against this kind of disruption need to seek opportunities that are inherently more robust and resilient.
“For that, you need to have what engineers would think of as “modularity”; i.e. a system built in such a way that when one part fails it doesn’t bring down the whole system. You also need redundancy, which means not trying to run things with the minimum margins of safety you can get away with. You’ve had banks and insurers talking about ‘surplus capital’, as if it’s possible for businesses to have too much money.”
Figure 3 shows how companies’ resilience, expressed as sound balance sheets, is reflected in their performance so far in 2020.
Figure 3: Strong balance sheets compared to global equities
Consider a range of possible futures
It’s not easy, however, to take these ideas on board. Individual investment ideas must collectively amount to an optimal and efficient portfolio to build resilience. This is where portfolio construction makes a difference. Correlation analysis helps ensure risk exposures are diversified, portfolio optimisation techniques can find the most efficient balance of allocations across assets, and scenario analysis can reveal the downside risk of an investment idea.
Investors should consider all possible outcomes – including the worst-case scenarios – and build portfolios from there, a principle equally applicable in the real world. “We tend to have a more optimistic view of the future, partly because we imagine we have more control over the outcome than we do. In other words, when it comes to our decision making, we tend to ignore the downside – it’s called the illusion of control,” says Annie Duke, World Series of Poker champion and author of Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts.
Analysing scenarios, as shown in Figure 4, allows us to see what would happen to our investment returns in our central case (blue line), if things turned out better than we think, and if things turn out worse than we expect. It also clearly shows there is a point where downside risk becomes far too big to take just to make a few extra basis points in returns if things go to plan.
Figure 4: Scenario analysis: targeting the optimal risk level for performance and resilience
Done properly, such an approach allows portfolio managers to shed the “illusion of control” and build resilience into every investment decision.
Volatility in perspective
When markets are at their most stressed, it may seem that all asset prices will collapse, and it is extremely difficult to protect portfolios. In such circumstances, often the best thing to do is wait out the downturn and resist the temptation to sell. In other words, do nothing.
As Figure 5 shows, even highly volatile equity markets regain lost ground given enough time.
Figure 5: SPX Total Return index over time
“I should just make a commitment that, if the market goes down three per cent in a day, my reaction as an investor will be to do nothing,” adds Duke. “No matter how much I think, having observed that downside outcome, that I should sell, I know in advance that my reaction will be to do nothing, and I am much more likely to behave in a rational way”.