Building and maintaining diversified investment portfolios

One common mistake that we notice from advisors about investors in general is a level of inadequate diversification. So that's what we call sometimes hyper concentration. And that really means an exposure to specific stocks, assets, more in general, regions or factors that are not really consistent with a broad exposure to financial markets. So that, for instance, could be having an investors that have few stocks, one, two or three stocks and a large balance associated with those.

So that really gives an exposure to only a few idiosyncratic elements in the portfolios that can bring to a lot of risk and not really harvesting on the diversification benefits that you might have from a multi-asset portfolio. And on top of that, those assets, if there are stocks, for instance, they might belong to the same industry or to the same region, so on top of that, having a level of correlations that are very high and really do not help the portfolio as a whole. Another misconception, maybe more of a misconception than a bias is associated with the idea that the more assets an investor has in their portfolio, the better it is for diversification benefit. That is not necessarily the case.

One aspect is the number of assets that are in the portfolios. Another aspect is the coverage that those assets bring in terms of financial exposure. So an investor might have many funds, but those funds are very niche, very specific in nature, and that might not give them a broad exposure to financial markets and to investment opportunities. Whereas with maybe fewer building blocks that are basically constituted of thousands of securities, you might get much broader exposure to financial markets and diversification benefits in that way.

So sometimes when it comes to portfolio construction and asset allocation, less is more from that perspective.

The Vanguard framework to portfolio construction is really an overview. I would almost call it a menu of what the capabilities, Vanguard's capabilities are in the multi-asset space to construct multi-asset portfolios that are targeted to specific goals and objectives. So it's really a large framework that allows you to identify different methodologies and approaches to achieve different goals. The way that we do that is because we acknowledge that different goals might require slightly different approaches to asset allocation and optimisation. And in the framework, we identify four key ways of categorising multi-asset portfolios.

And to be honest with you, there are many ways that multi-asset portfolios can be categorised. So you can look at them through different lenses. But one way of looking at it is by categorising following four different approaches. The first one is what we call the market-capitalisation-weighted approach. So these are portfolios that follow the idea of adding an exposure to different assets that is consistent with their market cap valuation.

A second approach is what we call active-passive blending. So these are portfolios that are meant to blend in an efficient way active exposures, active strategies and beta passive exposures. A third way of looking at it is through time-varying portfolios. That's how we call portfolios that are meant to change time after time in order to react and take into account changes in our market expectations associated with returns, volatilities and correlation.

Last but not least, another approach that we have is what we call strategic asset allocation, model basis strategic asset allocation. So those are portfolios that are meant to be efficient over the very long term in what we call equilibrium assumptions that take into account our capital market assumptions, but not in a way that would necessarily change tie after time.

So it wouldn't require an investor to make changes that can also bring higher costs associated with rebalancing.