How diversified is your portfolio?
With government bond yields close to 3%, the press is awash with comments about an inevitable collapse in bond prices. As a result, many investors have been tempted to forego exposure to government bonds (aka gilts). We would argue that such a strategy could leave you in danger of reducing your portfolio’s diversification to meaningless levels.
We are unsettled by some of the anti-gilt analysis because it encourages investors to replace gilts with junk bonds, absolute return funds or increased equity investment in a misguided attempt to reduce risks. In normal conditions, such a shift would be intuitively wrong, but in today’s world, such moves are somehow accepted as rational.
The motives for these shifts are riddled with inconsistencies and are increasingly vulnerable to the risk of poor forecast. Never mind the seemingly odd logic which suggests that simply because “Asset A” is out of favour, “Asset B” is automatically in favour. What is most damaging is the notion that a wholesale shift from government bonds can be exercised without reducing diversification.
Diversification is often linked with that cliché about eggs and a basket. However, care should be taken when choosing to diversify with increasingly exotic funds.
Considered diversification is about so much more. At the heart of a genuine attempt to diversify is a drive to reduce unnecessary risks. This requires a deeper understanding of the interplay between the broad asset classes as we move from one economic condition to the next.
However, the economy is very difficult to forecast accurately. With all of the research capability at the Bank of England, the Treasury and The City, we still cannot describe how the UK economy will look later this year, let alone ten- or twenty-years hence.
Our starting point then must be for the inclusion of assets that we can expect to perform well in one, or more, of the following four economic conditions:
- High growth / low inflation,
- High inflation / low growth,
- High growth / high inflation,
- Low growth / low inflation or disinflation.
Gilts perform well in two of the four conditions (1 and 4) and have the added benefit of being increasingly attractive in times of stock market panic. Index-linked gilts and overseas government bonds perform well in periods with higher domestic inflation with mixed performance in times of panic.
In foregoing exposure to gilts, investors are shaping their portfolio for just two of the four potential economic environments highlighted above.
In these instances, corporate bonds are not a substitute for government bonds since they share some equity-like properties. What is more, investors are increasing their portfolio’s sensitivity to falls during times of panic. Given investors’ propensity to sell out of falling markets, this latter tendency is far more damaging in the long-run than one might think.
We are not so contrarian as to suggest that returns from government bonds will be terrific in the next year or so. Reduced exposure to government bonds may or may not be appropriate for some investors – those in doubt should consult their Financial Planner. But if investors are to reduce government bond exposure, they must do so in the full knowledge that in the long-run they are increasing risks, not reducing them.
If you’d like to discuss our thoughts on investment strategies give the team a call on 01462 687337 or email email@example.com.