Markets are walking on eggshells as the outbreak of coronavirus disease (COVID-19), first reported from Wuhan, China in late December 2019, is wreaking economic havoc. Data from the world’s second largest economy shows a plunge in business activity in the last month, including massive declines in passenger traffic, electricity generation, shipping volumes and real estate transactions.
Drawing on figures from the 2003 SARS outbreak, and considering potential working days lost, James Carrick of LGIM estimates that the Chinese economy could contract at a double-digit pace in the first quarter of 2020. Consensus figures for the country’s economic growth have been revised down from 6.1% in 2019 to 4.5% in 2020, and the impacts extend far beyond China.
Widespread travel shutdowns have severely impacted air travel volumes, and the airline industry is set to lose $29.3bn in revenue – a figure roughly equal to its net profits in 2019. Along with airlines, these first-order impacts are being felt by hospitality chains, luxury goods makers and retailers as consumers stay away from the shops and travellers put off holiday plans.
Second-order impacts are still coming down the line via global supply chains, as Chinese factories remain closed, leading Jaguar Land Rover to warn that its UK-based factories could run out of car parts, and Apple to warn of possible iPhone shortages.
Managing investment risk
Albeit with a curious delay, capital markets have responded to this bad news by selling down equities and commodities to buy safe-haven assets including the US dollar, treasuries and gold. Within the space of a few days in February, the MSCI All Country World Index dropped 7.5% and the gold price lifted 8.5% to a five-year high.
These reactions suggest that COVID-19 was unanticipated by the investment community. Unfortunately, the world of investing is filled with such risks and uncertainties or, as Donald Rumsfeld put it, “known unknowns and unknown unknowns.” If anything, the impact of the coronavirus – which is still not fully calibrated – underlines the importance of managing risk as a first principle in any investment decision.
Here many investors choose to “buy the dips,” or “sell based on strict stop-loss limits.” But while these two risk management strategies are underpinned by clear-minded principles, the success of these approaches appears mixed. Rather, the evidence suggests that a more nuanced risk-management approach is needed.
The investment tool that immediately presents itself here is powerful, elegant and available to all investors: diversification. Sadly, however, diversification is often misunderstood, which leads to a miscalculation of its benefits and the mistreatment of the tool.
As witnessed in the current COVID-19 environment, in times of heightened anxiety and uncertainty, investors will often favour a “safe asset” that gives a stable return. To get this “safe and smooth return,” investors will sell out of other riskier asset classes – say real estate, shares, private equity or commodities – with less knowable returns. Indeed, unless you are a roller-coaster lover, it even seems logical to always choose a stable return (of 5%, say) over a bumpy return (of the exact same 5%).
But selling everything “risky” in times of stress to crowd into a “safe asset”, such as cash or treasuries, may not be as rational as it seems at first blush – especially if you have a long investment timeline.
To illustrate, let’s imagine you find a stable, single asset investment that will give you a guaranteed 5% per annum over the next 25 years. If you invested R500,000 today, it would be worth nearly R1.7 million at the end of the term.
However, if you shunned “the safe asset”, and instead stuck with a portfolio of multiple assets – say some cash, gold, government bonds, real estate and equities – that also gave you an average 5% per annum as a basket, you could end up with a substantially higher investment balance after 25 years. Jeffrey Levine, writing in Forbes, refers to this as the “diversification premium”.
The diversification premium at work
But how could a multi-asset portfolio offering the same return of 5% per annum produce a bigger investment result? Logic would suggest that if the diversified portfolio has the same return as a single asset portfolio, the two portfolios will produce identical results.
To demonstrate, let’s now imagine a new, diversified, multi-asset portfolio with the five asset classes mentioned, and let’s assume “typical” returns for the asset classes as depicted below, and give them 25 years to work together. Here enters the diversification premium.
This second diversified portfolio would have finished the 25 years with a net worth of R2.3 million – 36% higher than the “stable 5%” portfolio.
To explain this outcome, the initial portfolio returns are identical, and the two portfolios would each grow by R25,000 in the first year. But, with enough time, the compound growth of the higher-returning investments, namely real estate and equities in the diversified portfolio, more than make up for the lower-returning investments of cash and precious metals. This results in a progressively higher average weighted return for the second portfolio, culminating with roughly a 7.5% total weighted return by year 25.
As time lets the power of compounding assert itself, the second diversified portfolio therefore begins to accelerate away from the “smooth” single asset portfolio – a difference Levine calls the diversification premium.
It’s worth noting that in the real world of COVID-19, trade wars, Brexit and load shedding, returns won’t have the same shape as the hypothetical portfolios given here. And in some cases, the premium may not be worth pursuing – for example if you are just a few years from retirement or if you cannot afford or tolerate downside risk.
Also, while the examples here show investments growing over time – as we would expect, otherwise why bother investing – there are no guarantees. One of the asset classes making up the diversified portfolio could fall over 25 years (as recently seen in Japanese equities), or it could be that all of them, except the safe asset, fall together for some time in a synchronised drawdown (seen in the global financial crisis).
However, if the long-term goal is to grow your investment, there is a real, and often sizeable, “diversification premium” that can be achieved through proper portfolio construction.
So, the next time a COVID-19-type crisis hits and you feel the temptation to “run for cover” or buy a “safe 5%”, remember that not all 5% returns are equal. Ultimately, investing is not about avoiding risk, but managing risk, and diversification is one of the most powerful tools available to both manage risk and own returns.