What recent market downturns can teach us about portfolio diversification

Globe and Mail

7 days ago

Most investors understand that diversification can help preserve portfolio values when markets are volatile. But an asset mix that worked during one market downturn may not have the same stabilizing effect in another, money managers warn.
Bonds have epitomized this point in recent years. They helped investors stave off losses during the 2000 dot-com market meltdown, the 2008-09 global financial crisis and the pandemic-driven downturn in 2000.
But 2022 was a different story. Instead of balancing out a portfolio, bonds fell alongside stocks when inflation surged, causing investors to question the validity of the conventional balanced portfolio.
Bonds helped during the tariff-driven market sell-off in April, but other diversification options, such as gold and European equities, were better bets.
'It highlights that you can't use plain vanilla bonds as a portfolio diversifier anymore. You need to diversify the defensive portion of your portfolio,' says Craig Basinger, chief market strategist at Toronto-based Purpose Investments Inc., adding that each market correction has different causes.
Diversification often includes bonds, alternative investments (such as private equity and hard-asset real estate), gold, currency (such as the U.S. dollar) and securities in different geographies such as Europe and Asia. Investors have more choices than ever to add these mixed assets through a growing list of exchange-traded funds and mutual funds. Some advisors also add alternatives to their portfolios using private market funds.
Added diversification could mean more muted portfolio returns when equities are soaring, as they did in 2023 and 2024. Still, Mr. Basinger says a mix of assets can be an important portfolio ballast when markets correct. Each downturn is also driven by unique circumstances, Mr. Basinger notes, which makes it hard to predict which asset will work best.
Consider the U.S. dollar, which is usually a safe bet when there's global economic uncertainty, but not lately. The U.S.-led tariff war and concerns about the country's debt have led to a drop in the greenback. Still, Mr. Basinger says the U.S. dollar and bonds could become havens if the economy weakens.
'You can't give up on these different diversifiers even if they didn't work in the last correction,' Mr. Basinger says. 'You have to acknowledge that you don't necessarily know what's going to work and need a more diversified defence.'
Ben Jang, portfolio manager at Nicola Wealth Management Ltd. in Vancouver, says alternative assets can provide stability when markets are volatile and if other diversification vehicles such as bonds, gold or currencies don't work as expected.
'You need to go outside the traditional box to provide diversification in today's environment,' he says.
His firm invests in equities, bonds and alternative assets, including hard-asset real estate, private equity, infrastructure, private mortgages and private debt.
The alternatives are also diversified to help balance portfolios. For example, if higher interest rates create headwinds in real estate, he says private debt assets would experience tailwinds as financing rates typically float with interest rate movements.
'They're examples of true diversifying assets to hold together to create balanced portfolios,' he says.
Nicola Wealth has become more defensive given market uncertainties around tariffs and a possible recession. In public equities, Mr. Jang is focused on companies with stable and growing dividends and diversification into global markets, such as Europe. His bond portfolio is tilted toward mid-duration corporate bonds.
'Bonds will continue to be a diversifying factor and a bit more defensive than equities,' he says.
Brent Joyce, chief investment strategist and managing director at BMO Private Investment Counsel in Toronto, says diversification isn't a foolproof investment strategy, but he believes it's better than the rest.
'There's no perfect elixir that, if I diversify, I don't have to worry about anything else,' he says.
Some asset classes will always underperform others in a broadly diversified portfolio, he says. The goal is to smooth out the volatility during market corrections, whether driven by external shocks such as COVID-19 or tariffs, or the market imbalances behind the dot-com bust and global financial crisis.
'If something doesn't work, it doesn't mean diversification is broken. It will work over time,' Mr. Joyce says.
He says the right diversification strategy starts with a financial plan, weighing factors such as risk tolerance and investment time horizon, and then understanding what diversification can and can't do.
'With diversification, you're not going to get the best performance [and] you're not going to get the worst. But, over time, you're going to get better than any other strategy I've come to know,' Mr. Joyce says.
Also, diversification isn't a set-and-forget strategy. He says assets should be rebalanced regularly to ensure investors have the right asset mix that aligns with their financial plan.
'It's about having discipline and a methodical approach,' he says.