With financial markets expected to experience increased volatility as tensions in the Middle East flare, investment executives caution that diversifying risk in portfolios has never been more important.
Earlier this week, following Israel’s invasion of Lebanon, Iran launched ballistic missiles at several military and security targets in Israel, prompting another alarming exchange of threats between the two states.
With Israel vowing to launch a “painful” response and Tehran warning it would initiate “vast destruction” in response to any retaliation, markets are expected to be in for a rough ride.
With uncertainties and tensions continuing to weigh on financial markets, safe haven assets like gold and the US dollar continued to appreciate on Thursday.
Speaking to InvestorDaily, Gopi Karunakaran, co-chief investment officer at Ardea Investment Management, explained that for a long time, investors and traders have been more willing to invest in higher-risk assets, meaning that the value of diversification in portfolios has been somewhat forgotten.
“Exogenous event risk, whether from geopolitics or other sources, provides a good reminder that diversifying risk can be helpful in dampening portfolio performance volatility to a level that is consistent with an investor’s risk tolerance, while also mitigating the risk of intolerable losses due to extreme events,” Karunakaran said.
“Portfolio risk diversification is really all about diversifying equity risk, that is reducing total portfolio volatility and drawdown risk in scenarios where equity markets incur large losses.”
While alternatives are often perceived as equity risk diversifiers, Karunakaran warned that many alternative investments have significant embedded equity beta, which tends to manifest in periods of market stress.
“This means they appear to be portfolio diversifiers in good times but become equity-like in the bad times when equity markets fall, which is precisely when their perceived diversification benefits are most needed. This is like an umbrella that only opens on sunny days. It is not fit for purpose,” he told InvestorDaily.
He also cautioned high-quality government bonds, often touted to be the defensive asset class of choice, “are no longer as reliable as they used to be” in a regime of higher inflation uncertainty and higher government debt levels.
“Reliable risk diversification comes from adding investments whose underlying return drivers are genuinely different to the factors that drive equity returns, particularly in extreme scenarios,” Karunakaran said.
Similarly, Arian Neiron, chief executive and managing director at VanEck Asia-Pacific, noted certain assets can help “cushion” market volatility. Speaking to InvestorDaily, he reiterated the importance of investing across asset classes that are not highly correlated.
“When volatility spikes, whether it’s due to escalating tensions in the Middle East, systemic crises or other market events, investments that are more defensive in nature, such as gold bullion, gold equities, government bonds, the US dollar and US treasuries tend to cushion the portfolio while other riskier assets fall,” he said.
“This is why, in a strategic asset allocation context, many investors include alternatives like gold bullion and US treasuries, which have a place in portfolios as low correlation to traditional asset classes like equities.”
Ultimately, maintaining a long-term outlook is crucial given volatility tends to dissipate over time, Neiron said.
“Successful long-term investors survive short-term falls by sticking to investment principles that have withstood the tests of time. For portfolios, this may include better diversification,” he said.
Describing diversification as “crucial”, Ashley Glover, head of sales trading at CMC Markets, highlighted the importance of spreading risk across asset classes.
But he also believes volatility can prove fruitful to an extent, causing investors to potentially adjust asset allocation or portfolio sizing based on their risk tolerance.
Additionally, volatile markets can present buying opportunities, Glover said.
“High-quality stocks or other assets may become undervalued, offering long-term growth potential,” he added.
While gold and cash are well known diversifiers, he highlighted higher risk assets, which, when well considered, can perform defensively in portfolios.
“For example, in times of increased geopolitical uncertainty, we often see defence stocks outperform. This is currently playing out in stocks such as Lockheed Martin, which has increased by more than 50 per cent over the last year,” Glover said.
“Locking in big gains from cyclical equity assets can help offset any losses to portfolios from negatively correlated assets.”
