Investment | 17 January, 2019

The importance of diversification for investors

Alberto Villasán Investment and Markets Director

The highest levels of debt in history …

On many cases, the positive or negative performance of financial markets triggers a certain distancing of investors from economic reality and companies’ fundamentals. Periods where markets are performing well lead us to lose the feeling of risk to some extent, while during periods of poor performance investors tend to become pessimistic, often forgetting the value of financial assets and diversification.

In an attempt to be objective and trying to isolate ourselves from such feelings of optimism or negativity, whichever it may be, the reality is that the debt levels of governments and companies with respect to GDP are at a record levels, something we should take into account when investing.

The investor's chief problem

“The investor's chief problem, and even his worst enemy, is likely to be himself” This phrase of Benjamin Graham (considered to be the father of 'value investing', is without a doubt what has stuck with me for a long time and that I try to remember often.

.. have caused 10 years of very low or negative rates …

As we have said on previous occasions, the high levels of debt in the world ‘s main economies have led central banks to keep rates close to zero or negative in most developed economies.

Additionally, not only have rates remained at abnormally low levels over the past 10 years, but public spending has also risen significantly causing high deficits at the same time as they support and stimulate economic and business activity.

… which has kept “alive” companies and countries that in other circumstances would have gone bankrupt.

This injection of “adrenaline” has allowed entire sectors and specific companies to artificially benefit, being able to fund themselves at extremely low interest rates in historical terms and paying yields on their debt well below what their financial position and solvency would suggest.

In many cases even, significantly increasing the level of a debt that already seemed unsustainable in the past. These companies are colloquially known as “zombie companies”, in reference to the fact that in normal circumstances they would not be able to maintain their activity.

How emotions affect investment decisions?

Our emotions influence our decisions. It is vital therefore that we analyse how emotions impact investment decisions, and according to our investor advice and the favourable market indicators, we can reach success when investing.

 

Although a large part of them will not be able to pay their debt …

It is difficult to know when or how, but as investors we must accept and expect that some of these companies will not be able to meet the repayments on all of their debt for a variety of reasons.

Many of them will not be able to withstand the next economic recession, some will be clearly harmed by the eventual rate hike by central banks and others will simply cease their activity as a result of the exponential increase in the level of their debt with respect to their own funds.

…for this reason, portfolio diversification is more important than ever…

Even being optimistic in the short term and adding apparently top-level companies into our portfolios, we must apply the principle of prudence and think that at some point the reasonable thing is that someone (companies, individuals and countries) will not be able to meet their debt repayments in the medium and long term.

… both in the number of issues and in sectors and countries.

Diversification should not only be understood as the number of issues or bonds that we have in the portfolio, we also have to make sure that it is properly diversified in terms of sectors and countries.

As a general rule, we would say that a portfolio of investment grade bonds must have at least 25 issues, while if the companies have a lower investment grade, then the minimum number in the portfolio should be at least 75. The addition of securities always has a positive effect in terms of diversification and does not have to be detrimental to profitability as long as the IRR of the incorporated bonds is equal to or greater than that of the portfolio.

Given the high levels of debt, and taking into account that our main objective is the maintenance and capitalisation of assets in real terms, now more than ever we consider diversification in investment portfolios to be vital.

Related news

The world stock market hits new all-time highs

The intense momentum or positive inertia on the financial markets today has catapulted world equity indices to new all-time highs, particularly highlighting the monthly performance both by countries in Europe, driven by the election results in France and those more closely tied to the emerging economies.

How does the monetary politics affect our portfolios?

Draghi’s statements at the end of June indicating that reflationary forces (higher nominal growth and inflation) were replacing the deflationary fears of previous quarters, had a swift impact on the financial markets, producing sharp increases in long-term interest rates and a subsequent fall in bond prices across almost all the geographic regions.