Diversified Portfolios More Important Than Ever

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Text transcript

Vjosana Klosi. I’m a director in portfolio construction with CIBC Asset Management.

Asset allocation helps establish a framework of an investor’s portfolio. By having an investment professional who understands and analyzes the risk and return trade-off between the various asset classes at any given time, we’ll be building balanced portfolios with higher risk-adjusted returns throughout any given asset class.

An asset allocation plan also helps avoid common investor mistakes, such as an overconcentration in familiar asset classes. An example is the overweighting of Canadian equities by Canadian investors. 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. This may leave the Canadian investor with considerable concentration risk into energy, industrial and financial sectors, which dominate the TSX. They comprise two-thirds of its value, and their performance is very strongly correlated and interconnected. This Canadian economy reliance on all oil prices and commodities highlights the higher volatility of Canadian equities versus U.S. markets.

Moreover, this has broader implications for the strength of the Canadian economy as the energy sector accounts for about 8% of the Canadian GDP.

Research by the Bank of Canada in response to prior commodity price shocks has found that a 45% decline in oil prices leads to 1% contraction in GDP for the quarters that follow.

In addition, the positive correlation of the Canadian currency to the Canadian equity market due to both being correlated to oil prices indicates that adding more diverse sources of currency and equity exposure to multi-asset portfolios would reduce its volatility.

Another dominating risk is the high Canadian household-debt-to-GDP levels. The household debt currently stands at 100% of GDP, mostly a function of indebtedness of the housing sector. This factor contributes to the increased risk of being over concentrated in Canadian equities.

An asset allocation framework [should help] investors to remain invested in the long term and avoid chasing performance of dominating asset classes. In fact, this common investor mistake has resulted in a measurable gap in performance of what the investor earns and what the fund manager is reporting. In general, the gap widens around dramatic market declines because of higher observed outflows near the bottom that miss out on subsequent dramatic rebounds in the stock markets.

Lastly, a well-thought-out asset allocation plan protects the portfolio from unintended risks in the long term. Even in well-diversified portfolios, asset correlations between the various asset classes tend to increase during financial crises. Historically in a typical balanced 60/40 portfolio, equities have contributed 90% of the volatility, while fixed income contributes only 10% of the volatility during crisis. This 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.