How to avoid heavy portfolio drawdowns

Have you heard the famous English proverb “Don’t put all your eggs in one basket”? If we simply say that this is the basic principle of diversification, most likely, you will have new questions: how to correctly transfer this analogy to investments, is it enough to buy shares of three companies for diversification, and so on. We have collected in this material simple answers to questions about the competent distribution of assets.

Diversification is investing in different assets to reduce risks. For example, if you invest only in shares of Gazprom, Rosneft and Lukoil, then this can hardly be called diversification, because all three companies are Russian and belong to the oil and gas industry. If, for some reason, natural resources become devalued one day, you will lose most of your savings. It is important to distribute assets across different classes, countries and industries.

Nobel laureate in economics and author of modern portfolio theory Harry Markowitz proved in the middle of the last century that diversification is the only «free lunch» for an investor (Diversification is the only free lunch). This means that by combining various assets with each other, an investor can achieve higher returns for a given risk.

There are at least four types of diversification:

In an investment portfolio, you should use not only stocks, but also bonds and commodities.

Each asset class is unique: stocks, despite high volatility, enable investors to capitalize on economic growth, provide long-term capital gains, and provide effective long-term inflation protection.

Bonds and other debt instruments can provide an ongoing stream of income, but they cannot protect against unexpected price increases.

Assets that protect investors from inflation in an environment of both moderate and high price increases include:

Conclusion:

The key argument in favor of country diversification is the unevenness, cyclical nature of economic processes. Those countries that are now developing more actively than others may lose their leadership in a few years. You can see how leaders change approximately every 15 years by studying the dynamics of the US market (FXUS) and developed markets without the US (FXDM). Here is their historical comparison:

Dynamics of the MSCI USA Index, MSCI World ex US Index, 1970–2021

To understand how the shares of countries in the global economy have changed over a longer horizon, take a look at the diagrams from

Conclusion:

Sectoral asset allocation is also important for the long-term investor. The predominance of one sector in the portfolio imposes additional risks. For example, if an investor only invests in a gaming industry company (FXES), he exposes himself to the specific risks of that industry. They can be avoided by, say, adding broad market stocks.

The industry distribution of FinEx ETFs can be found on the main information pages for each fund.

Now a significant share of the global distribution is occupied by the IT sector, but this does not mean that it will always remain dominant. If in 1900 you invested all your funds in the US railway transport (the most promising industry at that time), then by 2021 you would have lost a significant part of your savings.

Sectoral distribution of the economies of the USA and Great Britain in 1900 and 2021

Conclusion:

Investors can improve diversification with securities denominated in different currencies, each of which behaves independently of the share price. Different markets and currencies can react to market cycles and world events in different ways at different times and to varying degrees.

During periods of weakness in the US dollar, the presence of assets in other currencies in the portfolio can protect the investor from losing the purchasing power of the dollar and increase the return on investment.

US dollar index and its market cycles, 1980-2020

To explain the benefits of currency diversification, consider an example that

Conclusion:

Correlation

The lower the correlation between assets, the better for the investment portfolio. In our quarterly risk monitor, we publish correlation matrices for all FinEx ETFs.

Correlation of FinEx funds for three years in rubles

Selecting funds in a portfolio based on historical correlation data can be difficult. It should also be remembered that past performance cannot predict the future. However, there are universal recommendations with which you can avoid severe portfolio drawdowns and take advantage of all the benefits of diversification: