3 Diversification Strategies to Avoid in 2022

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. It's shaping up to be yet another terrific year for U.S. stocks. As such, many investors may be thinking about how to effectively diversify their portfolios for 2022. Joining me today to discuss diversification in general and which strategies may yield the greatest benefit is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy. Nice to see you.

Amy Arnott: Hi, thanks for having me.

Dziubinski: You did some work earlier this year, actually some in-depth research, on portfolio diversification and correlations in general. So, let's take a step back and first talk about what portfolio diversification is and why it's important.

Arnott: Sure. So, portfolio diversification is one of the most important principles for effective investing. So, by adding additional securities you can reduce your security-specific risk. And then, if you diversify across asset classes, you can also reduce the risk of your entire portfolio. So, this goes back to research Harry Markowitz did in the 1950s, and he found that the risk of a portfolio isn't just the risk of each component added up, but it also depends on the correlation between those different portfolio components and how closely they move together. So, if you can find securities or asset classes that have relatively low correlations, you can actually reduce your portfolio's overall risk profile.

Dziubinski: Let's talk a little bit about that and the research you did earlier this year. You looked at the diversification benefits of adding different types of asset classes and styles to a U.S. equity-focused portfolio. What did you find to be the best diversifiers?

Arnott: We looked at both the shorter-term periods, specifically 2020, and longer periods going back 20 years or so. And the patterns that we found were actually pretty similar between both the short term and the long term. So, we found that fixed-income securities--including cash, short-term bonds, and longer-term bonds, especially higher-quality bonds--were the best diversifiers. Gold actually did relatively well as a portfolio diversifier. And then, some other areas such as international stocks that you might expect to add diversification value actually ended up moving more closely in tandem with the U.S. market than a lot of investors might have expected.

Dziubinski: Then, let's talk a little bit about a few different types of investments that you might think are good diversifiers but in fact haven't been, according to your research. Commodities was one of those. They haven't really been terrific diversifiers. Let's unpack that a little bit.

Arnott: Sure. So, commodities are basically raw materials that are used to manufacture other goods. And their prices tend to be driven by supply and demand. And in the past, we found that commodities can be fairly good portfolio diversifiers, but over the past several years, their correlations have actually trended up. Another key aspect of that is the fact that a lot of major commodity indexes are very heavy on energy, which obviously hurt performance when we saw oil prices plummet in early 2020.

Dziubinski: Now, another pocket or type of investment that hasn't really been a super diversifier that you might expect are alternatives. Talk a little bit about that.

Arnott: Right. So, alternatives are another area that I think a lot of people think of as being good for diversification, but they may or may not actually work that way. So, things like bear-market funds obviously move in the opposite direction as stocks. So, they did provide some diversification value. But other alternatives actually had fairly high correlations with the U.S. market.

Dziubinski: And then, you did mention fixed-income securities earlier in your comments, and long-term Treasuries have in fact been really great diversifiers over time. But there are other types of bonds that haven't been as effective at diversifying an equity portfolio, those being emerging-markets debt, lower-quality corporate bonds, and bank loans. So, let's talk a little bit about those.

Arnott: Right. So, these are all things that have kind of security-specific risk or other factors that drive their performance. And in the case of something like high-yield bonds, we actually see that they have a fairly high correlation with stocks. So, even though they are bonds and that you're getting a fixed coupon payment, if you're adding them to an equity-only portfolio, it's not necessarily going to improve your risk profile all that much. And the same thing applies to other areas like bank loans and emerging-markets debt.

Dziubinski: Amy, given all that, how do you suggest that investors think about diversification for 2022, especially if they have a pretty U.S.-equity-heavy portfolio?

Arnott: I think, one important thing to keep in mind is, we've heard a lot of negative things about bonds, with the idea being they've performed so well over the past three or four decades. Interest rates are now close to an all-time low. They probably won't generate the same type of returns in the future as they did in the past. And all of that is true, but that doesn't mean that they don't still have a valuable role to play in a portfolio in terms of reducing risk. So, I would make sure that you have the right balance in your portfolio between stocks and bonds that fits with your time horizon and your risk tolerance.

And then, as you mentioned, international stocks are another important area to look at if you have a U.S.-heavy portfolio. So, the U.S. market has definitely been the best place to be over the past 10 years or so, and that was also true for 2021. So, now I think is a good time to look at your portfolio and the balance between U.S. and international and make sure you have enough of a balance between the two.

Dziubinski: Well, Amy, thank you for your time today and for these tips about how we can diversify our portfolios in 2022. We appreciate it.

Arnott: Thanks. Great to be here.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.