Are you diversified?

One simple test can tell you.

16 Aug 2018

Key takeaways

  • Investing in a diversified portfolio is often uncomfortable over short periods, but in the long run diversification is the key to a smoother and safer investor experience.
  • The UBS Chief Investment Office (CIO) currently sees two main areas of under-diversification: too much allocation to their home country's stocks and too little invested in core high-quality bonds.
  • While CIO is still bullish on the US market, the scope for further outperformance is limited.

By Justin Waring, Investment Strategist Americas, UBS

There's a simple test to tell whether you are diversified: if you're happy with everything in your portfolio, you're probably missing some important components.

When looking at investor portfolios today, the UBS Chief Investment Office (CIO) sees two common areas of under-diversification:

1) Home bias
There are a lot of temptations that drive investors to over-allocate to their home country's market, and US investors have generally been rewarded for their "home bias" since 2010. But there's good reason to expect an end to the recent "America First" trend in equity markets. After all, the US is further along than other regions in the economic and earnings cycle, so other markets might offer more low-hanging fruit to fuel periods of outperformance in the coming years. So while CIO is still bullish on the US market, the scope for further outperformance is limited.

The US has gone through some painful bouts of underperformance—for example, from 2002 to 2007, US stocks drastically lagged emerging and international developed markets, with MSCI Emerging Markets gaining 353% and MSCI EAFE returning 129%, versus just 43% for the S&P 500.

2) Not enough duration risk
High-quality bonds have been one of the most disappointing parts of the portfolio recently. But now that the majority of the current hiking cycle is already priced into the yield curve (PDF, 1 MB), CIO believes that most of the pain for core bonds is over and—since we're already in the mid-to-late part of the current market cycle—the strategic benefits of core bonds will begin to shine through once again.

Core bonds are often frustrating to own between risk-off episodes, but they're an indispensable tool for rebalancing and taking advantage of short-term bouts of fear. That's one reason why CIO currently recommends a tactical overweight to 10-year Treasuries: fears of a 'bond bear market' are overblown, and intermediate-term high-quality bonds are an excellent hedge against stock market losses (PDF, 1 MB), which are the biggest risk for most portfolios. Short-term bonds or cash, by contrast, aren't as helpful at protection; after all, they are less sensitive to falling interest rates during economic soft patches.

Of course, there's another possibility
If you're comfortable, it could be a sign that you're diversified, but that you've already learned the most important investment lessons: that it's not healthy to look at your portfolio too often, or too closely, or to make big investment decisions based on short-term performance; that your portfolio will always underperform the best-performing asset class; and that there will always be something in your portfolio that looks like a "loser" based on recent performance.

If that's the case, congratulations! There's a good chance that you're both well-positioned and well-prepared to navigate the next bear market, whenever it comes along.

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