Diversification counts when uncertainty beckons

Pick the option that best describes your attitude to investing today:

A - confident
B - fearful
C - uncertain
D - all of the above

Economic messages and market signals blended with dramatic and tragic geo-political events are presenting investors with lots of conflicting information to digest.

The Brexit vote understandably unsettled markets while the glacial-like counting in our federal election added its own sense of uncertainty. Then came the tragedy and drama of events in France and Turkey over the weekend that added an emotional and human perspective.

Back home a range of research reports made media headlines forecasting falling or flat residential property prices in major cities - the traditional safe harbor of Australian investors.

In the midst of all this an industry colleague was questioning the role of another traditional investing safe harbor - fixed income.

The question is both valid and topical. It is hard to get excited about an investment where return forecasts around the globe are close to zero.

But when information is overloading you with mixed, at times opposing signals - the US sharemarket hit a new record high last week in case you hadn't noticed - that is as good a time as any to go back to first principles.

Vanguard has enjoyed success in 20 years in the Australian market based on four basic principles that guide the investment approach. Developing a balanced asset allocation using broadly diversified funds is at the heart of the approach.

That importantly incorporates fixed income as a key part of the asset allocation mix.

Vanguard's Global chief economist Joe Davis wrote in a recent blog that to build a multi-asset-class portfolio appropriate to a given goal and risk preference depends, primarily, on the following three characteristics of each asset:

• its expected return
• the expected volatility of those returns
• the correlation of the asset's return with those of other assets (i.e., its covariance)

Around the globe yields on government bonds are extremely low. So does that mean investors need to look elsewhere? Return is obviously a key measure of any investment but critically it should not be the only measure.

Why do investors buy US government bonds yielding less than 2 per cent and even with negative yields in other markets? Certainty is the answer. As one wag of a portfolio manager quipped recently - zero is a lot better than minus 20 per cent or 30 per cent.

One of the key principles of diversification is finding assets that are not correlated to other parts of the portfolio. When shares zig bonds usually zag which is the intrinsic value of bond holdings in a portfolio. So for investors bonds are really the defensive side of the equation.

A basic but important factor in building a diversified portfolio is to have assets within it that are not highly correlated and will not move in lockstep with a major asset class like local and international sharemarkets.

Vanguard's Investment Strategy Group has looked at the correlation levels between 10-year Australian Government bonds and the Australian sharemarket. When you look back to the late 1990s there was a positive correlation between bonds and shares. Since the global financial crisis in 2008 the correlation has remained in negative territory.

So despite the low yields on offer the diversification power of government bonds and fixed income remains as strong as it has ever been.

By Robin Bowerman
Smart Investing 
Principal & Head of Retail, Vanguard Investments Australia
20 July 2016