A diversified portfolio is always worth the effort

Diversification can feel like eating vegetables. You know it is good for you, but it is nowhere near as enjoyable as eating hot chips.

The US sharemarket offers some good options for Australian investors seeking to diversify. Picture: AFP

Diversification can feel like eating vegetables. You know it is good for you, but it is nowhere near as enjoyable as eating hot chips.

Fundamentally, diversification involves spreading your portfolio over a wide range of assets. Well-diversified investors can have the frustrating sense they don’t have enough of the latest hot asset. Equally, they are likely to be left with a sour taste from their exposure to the worst asset class of the year.

The beneficial effects of diversification occur over a multi-year period. The gains come in the form of a superior risk-adjusted rate of return, ensuring a smoother path to wealth accumulation.

At its heart, diversification is about owning investments that are driven by unique factors, with the expectation that when one set of asset classes “zig”, other asset classes “zag”.

Each asset class in a portfolio is expected to have positive return over time, the total return of the portfolio being the product of each individual holding. But the total volatility of the portfolio will be less than the sum of the individual parts because at any point in time, when one asset class is going down, there will be another going up.

Traditional asset class diversification combines stocks and bonds. Typically, when stocks fall, bonds rise and vice versa.

However, sometimes this relationship does not hold. Over 2021 and 2022, developed market bonds, including in Australia, experienced their largest losses in history, even as stocks also struggled.

We view 2021 and 2022 as outliers fuelled by very low starting cash rates and yields, and aggressive rate hikes by central banks. Simultaneous stock-bond losses are extremely rare. Based on UBS analysis, of all the 12-month rolling return periods since December 1925 in the US, only 2 per cent of those periods saw stocks and bonds fall at the same time.

With bond yields now higher, the long-term return potential of the asset class has been restored and we have seen a return of the historical relationship between stocks and bonds.

Another dimension to diversification is security and sector diversification.

It can be tempting to allocate a large share of wealth to several favourite stocks or even an individual stock to supercharge returns. The downside is such concentration makes investors vulnerable to very specific risks, for example supply chain disruption, a change in government policy or the loss of competitive advantage which can occur quickly. For example, almost overnight the Apple iPhone put Motorola and BlackBerry out of the mobile phone business.

Investors should also diversify across geographies.

It is natural to have a home bias, where many of the companies being invested in are household names, and there is comfort in familiarity. Franking credits are also an attractive addition to return. However, Australia is a small market.

To get exposure to themes like artificial intelligence, digitisation, biotechnology and power, investors must look outside of Australia and particularly to the US.

Lack of exposure to these big themes is being reflected in returns. In 2024, the Australian stockmarket returned 11.4 per cent. In comparison the US S&P 500 returned 38.2 per cent in Australian dollars, more than triple that of the ASX.

Calibrating exposures will depend on the risk you want to take, but it is worth noting that according to APRA, the average industry super fund invests around 55 per cent of its stand-alone equity allocation in overseas stocks, with the remainder in Australia.

Diversification works because it helps control behavioural biases. Recency bias is one such cognitive flaw. It is the natural tendency to overestimate the importance of recent news or performance.

Looking at annual returns for 14 major asset classes since 1999, the best performing asset class in one year has a 40 per cent chance of being down in the next year. A diversified portfolio reduces the impact of recency bias because the strategic or long-term asset allocation is based on long-term risk/return estimates.

Another benefit in terms of behaviour bias is that a diversified portfolio reduces the chances of selling at the bottom given that in a risk sell- off, any downside will be dampened by defensive assets.

Diversification is a timeless investing principle. At UBS we believe the best risk-adjusted way to achieve returns is a multi-asset-class portfolio. Right now we are attracted to the yield on highly rated Australian corporate bonds. We have a bias to shares and prefer the US market to the rest of the world including Australia. Within the US market we see an ongoing opportunity in AI-exposed stocks. Valuations are stretched, so we are also recommending a broad exposure to alternatives in the form of hedge funds, private equity and unlisted infrastructure, which should mitigate portfolio volatility and potentially boost returns.

Andrew McAuley is a managing director at UBS Global Wealth Management