Kevin Barr, Head of SEI’s Investment Management Unit, and Jim Smigiel, SEI’s Chief Investment Officer, continue a seven-part video series about asset allocation. Their second discussion centers on understanding the major sources of portfolio risk and providing diversification within stock and bond allocations.
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Kevin Barr: Hi, I'm Kevin Barr head of SEI's Investment Management Unit. Welcome to the second video in our Asset Allocation series. Today, we discuss our belief in diversifying our portfolios beyond the traditional risk investors expect when they buy stocks. To give us some insight on this topic, I'm again, joined by Jim Smigiel, SEIs Chief Investment Officer.
Kevin Barr: Jim, thanks for joining me today. Kevin Barr: To start most investors know the basic concept of diversification. Don't put all your eggs in one basket. We also know that including both stocks and bonds in a portfolio can provide greater diversification than including just stocks or bonds alone. During our last conversation, you mentioned that we try to provide diversification within our stock and bond allocations. Can you talk about what that means from a practical standpoint in an investor's portfolio?
Jim Smigiel: Sure, Kevin. When we think about diversification, we're trying to identify the major sources of risk in a client's portfolio. In essence, we want to know what bets the portfolio is making, and when they could potentially go wrong. Our goal is not only to understand those risks, but to manage them actively by balancing across as many exposures as possible. We don't want successes to hinge on just one or two major bets that would make for an unattractive risk return trade off. What we do want is to spread our risks around as much as possible, to help minimize the chance of the portfolio losing significant value due to one or two concentrated risk exposures that don't work out as planned.
Kevin Barr: So how does that make our equity portfolios different relative to more generic say 60/40 or 80/20 portfolios?
Jim Smigiel: Sure. Well, we mentioned last time that stocks are usually anywhere from three to five times as risky as bonds. So, in a 50/50 stock bond portfolio, you can see that stocks account for more than 95% of the risk of the portfolio itself. As you can imagine, the imbalance is even more extreme for an 80/20 portfolio. In terms of risk exposures, there's essentially no diversification at all. Such portfolios are typically expected to do well if equities do well, and perform poorly, if equities perform poorly. We try to make our portfolios more robust than that. We don't want portfolios that can essentially only succeed when stocks do well. So to make other asset types, besides equities actually matter in our portfolios, we also allocate meaningfully to Investment-grade bonds, Inflation-sensitive assets, and other Multi-asset products. Our goal is to give our clients the best chance of reaching their own investment goals. And, that means we don't want our portfolios to amount to a binary concentrated bet on equities alone. Kevin Barr: Well, Jim, it sounds like our portfolios are more conservative than what you might see elsewhere. Jim Smigiel: Actually, it's a common misconception that being more diversified necessarily means being more conservative. Or, that taking on less risk means we should expect lower returns. In fact, there are two different decisions investors are making here. The first is how much risk am I willing and able to take on? And, the second is what types of risk do I take on in order to make sure that I'm being rewarded as much as possible for that risk in the form of higher expected returns? The goal is to be well-diversified regardless of the level of risk the investor chooses to take on. In doing so, we strive to create portfolios that offer the highest expected return possible for a given risk tolerance. As you can see from the chart, whether you identify as a conservative investor with a lower risk tolerance or a more aggressive one with a higher appetite for risk, maintaining a diversified portfolio should offer a higher expected return than a portfolio that is more concentrated. Kevin Barr: So, Jim, what you're saying is that we can have less equity risks in a portfolio without reducing the portfolios overall risk or return expectations. Can you elaborate? Jim Smigiel: That's exactly right. So, there are lots of ways to achieve a given level of risk exposure. Let's say your risk tolerance dictates that you want a portfolio that sits somewhere between a hundred percent stocks and a hundred percent bonds on the risk spectrum. You could get to that risk level by splitting your money between stocks and investment grade bonds in some proportion, let's just say 50/50. Or you could allocate a hundred percent to high yield bonds, which are generally riskier than investment grade bonds, but less risky than stocks. You could also throw other assets into the mix, like commodities or emerging market debt. Allocating some amount to those assets along with traditional stocks and bonds, is another way to help meet your risk target through diversification. The important thing is that while all of these hypothetical portfolios may carry similar risk, they would not be equivalent portfolios. Some would likely offer meaningfully higher returns than others, which naturally makes them more attractive. As investors, we never want to take on risks that we are not rewarded for with higher returns. So for whatever risk level an investor wants to target, we want to maximize the reward award earned for taking that risk. Diversification is the clear answer for how to try to do just that. Kevin Barr: Thanks, Jim for the view into our philosophy and approach to building diversified portfolios. It really highlights the importance of only taking on the risk that you get paid to take. The next time we get together, we'll continue our discussion with a closer look at how and why we pursue more diversification even within the equity sleeves of our portfolios. Jim Smigiel: Looking forward to doing that.
The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Diversification does not ensure a profit or guarantee against a loss.
There are risks involved with investing, including loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from difference in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise.
High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI).