Diversified portfolios more important than ever

Avoiding home bias and boosting portfolio diversity is even more important in the midst of a pandemic.

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“The average investor has half of their equity allocation in Canadian equities, while Canadian equities comprise only 3% or 4% of the world’s equity index,” said Vjosana Klosi, director of portfolio construction at CIBC Asset Management, in an interview last month. 

Lack of diversification leaves the Canadian investor “with considerable concentration risk” tied to the energy, industrial and financial sectors, she said. The Canadian economy, which relies heavily on oil prices and commodities, can lead to higher volatility. 

Another hurdle for investors who give in to home bias is Canadian equities’ positive correlation to Canadian currency, since both are tied to oil prices, Klosi said.

As a result, she suggested considering diverse sources of currency exposure.

A report that Klosi co-authored earlier this year says that investors should generally avoid allocation plans that focus on one or two asset classes in general, as well as reliance on cash.

“While many conservative investors prefer the safety of cash over other asset classes, proper diversification over the long term has been shown to outperform most individual asset classes on a risk-adjusted basis,” the report says.

The report showed that equities (mainly U.S.-based) have garnered the highest annual returns in five of the last six years.

Of course, current market risks and potential volatility from a second wave of Covid-19 can’t be underplayed, nor can the weight of growing household debt-to-GDP levels that are “mostly a function of indebtedness of the housing sector,” Klosi said in the interview.

“Even in well-diversified portfolios, asset correlations between the various asset classes tend to increase during financial crises,” she said, adding that equities tend to contribute the lion’s share (90%) of volatility when compared with fixed income (10%). 

Given historically low interest rates, which aren’t expected to rise soon, the CIBC report offered a list of possible portfolio diversifiers. These include real assets, emerging market equities, floating-rate loans and multi-sector fixed income. The latter involves tactical allocations to securities such as global government and agency bonds, corporate investment-grade and high-yield debt, and asset-backed securities.

Alternative asset classes are another option that’s becoming increasingly important.

“[Volatility] can be partly mitigated through investments in alternative assets classes with distinct risk and return profiles, which helps solve for the performance of balanced portfolios and increases the probability of achieving long-term investment objectives for clients,” Klosi said.

Her overall tip to help investors avoid emotional mistakes and account for current risks is to continue to stress the value of long-term planning.

“An asset allocation framework [should help] investors to remain invested in the long term and avoid chasing performance of dominating asset classes,” Klosi said. “This common investor mistake has resulted in a measurable gap in performance of what the investor earns and what the fund manager is reporting.”

During dramatic market declines, mistakes are amplified, she said, because higher outflows near the market bottom often miss out on the rebounds.

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.