Think different: How equity diversity can reduce portfolio risk

Jonathan Boyd
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Think different: How equity diversity can reduce portfolio risk

Asset allocation is one of the most important investment planning decisions.

The key question: What is the best mix between stocks and bonds, and how should that mix change over time? By focusing on diversification, however, we may lose an important distinction: Not all equities are created equal.

Different types of stocks exhibit unique risk and return characteristics that can help offset the changing risks investors face. Better outcomes can be achieved by harnessing these traits, rather than simply holding the broad equity market and adding more bonds.

Although the philosophy of different equities for different investors may have fallen out of style, it predates foundational concepts such as modern portfolio theory and the capital asset pricing model by at least 50 years. It is worth revisiting.

A new view of risk

Although there are other ways to slice the market — by yield, by market capitalisation, by valuation — we found that beta, a measure of a stock's sensitivity to overall equity market risk, forms a relatively simple way to distinguish between growth and defensive companies.

Using more than five decades of historical data, we found that higher beta stocks were riskier and more volatile but offered higher returns than lower beta stocks. Which isn't surprising. But a compelling new perspective is revealed by reconsidering how volatility is measured.

The upside of a smaller downside

For investors with a shorter time horizon, such as those nearing retirement, defensive lower beta equities have delivered superior results in periods of market stress. 

This is why we focus on income-oriented stocks in portfolios for investors nearing retirement. These have had a more conservative profile that helps reduce the risk of losses while at the same time keeping a healthy allocation to equities, which offer higher long-term returns compared to bonds.

Plotting the beta cohorts against their downside capture — a measure of how exposed they are to broad market pullbacks — draws out an important distinction. Traditional measures of risk weigh upside and downside outcomes equally, but sometimes losses hurt more.

Put simply, low-beta stocks demonstrated less downside and more upside than expected. Compared to simply holding the entire equity market, the most defensive Q1 (low beta) portfolio has yielded nearly the same average return for a more than 40% reduction in downside capture risk. Adding bonds to a portfolio could have lowered downside, but with far lower average returns. The benefits of bouncing back For those with longer time horizons, such as young investors with the stomach to stay the course in the midst of selloffs, more cyclical, higher beta equities have yielded better outcomes. This is why we emphasise growth stocks in portfolios for investors early in the savings cycle.

To illustrate this point, we plotted the beta cohorts by their volatility over a long-term holding period of 20 years. Portfolios that held higher beta equities would have earned higher total returns, helping offset the chances of inadequate savings at retirement, at a lower level of long-term risk compared to simply increasing exposure to the broad market.

Although high beta stocks tended to lose more value during market downturns, they often bounced back — a reflection of their growth-oriented nature.

Sure, short-term market volatility can be emotional and worrisome for those invested in higher beta stocks. But for those with the discipline to remain invested during volatile stretches, these corrections and selloffs may be eclipsed by the market's tendency to rise over multi-decade periods.

Far from a new idea

The equity differentiation strategies outlined here are not new but have fallen out of favour in an era of passive investing, indexing and market efficiency. This is unfortunate, as the often singular focus on portfolio diversification has led many to forget that equity diversity can be a powerful risk reduction tool.

Investors face varied and changeable risks as they age. So why should their equity exposure — often simply an allocation to broad equity market indices and typically via a low-cost index product — remain the same? By viewing the stock market not as a homogenous block but as a mix of individual issues with unique characteristics, better investment outcomes can be achieved.  

 

Sunder Ramkumar is a senior manager, client analytics at Capital Group