Something unusual has happened so far this year which might be a worrying portent of things to come: many well-diversified portfolios have lost money.
According to Trustnet a quarter of unit trusts in the mixed investment sector with 20-60 per cent in equities have lost money so far this year and a further 35 per cent have made less than 1 per cent. This is because losses on bonds and gold have offset modest gains in equities.
I say this is unusual because for years diversification has been easy. My chart shows the point. It shows annual returns on a portfolio comprising 50 per cent global equities, 20 per cent gilts and 10 per cent each in gold, sterling cash and US dollar cash. It has only rarely lost money, losing less than 10 per cent during the worst of the 2008 crisis and holding up well during last year’s slump in equities.
This has happened because falls in equities in recent years have usually been accompanied by rises in gilt prices and falls in sterling, which have boosted the sterling returns on gold and US dollars. The upshot has been a portfolio with little chance of significant losses and – thanks to bull markets in equities and bonds – high average returns.
This year’s losses, however, while small, warn us that diversification need not always make easy money. There are two particular risks here.
One would be a more extreme version of what we’ve seen this year – increased fears of inflation. These would raise bond yields, which in turn would force down the price of gold: it usually falls as yields rise simply because higher yields mean you sacrifice more income when you hold gold, making the metal less attractive. At the same time, though, equities could fall if investors fear that central banks will raise interest rates.
So far, we’ve seen only a hint of this; equities have largely shaken off fears of inflation and have edged up since December. A precedent for more serious trouble is 1994, when bonds and equities both fell.
For much of the last 20 years diversified investors have benefited from a negative correlation between gilts and equities, so losses on one have been offset by gains on the other. But this correlation need not remain negative. In fact for much of the 1980s and 90s gilts and equities rose and fell together in large part because of fluctuating expectations for inflation and interest rates. A return to that pattern would hurt diversified investors.
There’s a second danger. It lies in the fact that the worst losses on our notional diversified portfolio came during the early 00s when the tech bubble burst. The problem then was not merely that share prices fell so much as to swamp the profits on bonds. It was that the US dollar also fell, causing losses on US assets for a sterling-based investor.
In recent years, we’ve not seen that combination. In fact, the opposite: during the stock market falls of 2008 and 2020 sterling fell sharply, giving investors nice profits on dollars during tough times.
But as we saw in the early 2000s, this need not always happen. A loss of confidence in the US economy at the same time as a fall in equities would see sterling-based investors lose on two fronts. If the US tech giants were to fall out of favour with investors, so might the US dollar.
Of course, there’s a simple remedy for this risk. We could hold euros as these often rise against sterling if the dollar falls.
But that’s the point. For years, investors have been able to exploit a few low or negative correlations between gold, gilts, equities and dollars to build simple diversified portfolios which have delivered good returns and low risk. But correlations are not fixed facts. Instead, they vary with economic conditions. And there’s a danger that they will change so that simple diversification no longer works so well. If so, investors will need more assets or a more active approach to asset allocation.
Running balanced portfolios has for years been so easy that fund managers have made money for nothing. This need not remain the case.
