Dr. Francois Stofberg: Senior Economist at Efficient Wealth and the Managing Director of Efficient Private Clients, with specialist input from Christiaan van Zyl.

Nobel Prize winner Harry Markowitz famously said that diversification is the only free lunch in investing. In simple terms, this means that you can quite easily keep your expected level of return constant, or even increase your expected return, without taking on additional risk. Diversification is one of the most important principles in investing: It involves spreading your money across a variety of assets or even across asset classes.

Diversifying your investment portfolio holds many benefits but perhaps the most prominent one is reducing overall portfolio risk. No single investment is risk-free, and even the most stable investments can experience losses from time to time. It is, therefore, sensible to include various assets that are uncorrelated, which, in essence, means that the prices of the assets move independently over time. If one investment loses money, the other investments may achieve gains, offsetting some of the losses and thereby lowering the overall portfolio risk. Over time, all of the portfolio investments are expected to achieve an acceptable level of return but the uncorrelated nature of the individual assets helps to reduce the short-term volatility of the portfolio and, therefore, lowers the total portfolio risk.

A practical example of differentiating between assets within a specific asset class is to combine a healthcare stock and a mining stock in a portfolio. As the economic cycle evolves, the mining stock may experience impressive returns as the prices of resources tend to increase when an economy expands, while the healthcare stock may experience relatively muted gains. But, as we reach the end of the economic cycle, resource prices may start to decline, which is generally bad news for mining stocks, while the healthcare stock becomes more attractive as spending on healthcare tends to be unaffected by the economic cycle. Another alternative is to diversify a portfolio by investing in various asset classes. Asset classes are broad categories of investments, such as stocks, bonds, real estate and cash, or alternatives such as hedge funds and private equity, among others. Each asset class has its own unique risk and return characteristics, and are generally uncorrelated with one another. By investing in different asset classes, an investor can reduce their overall portfolio risk.

Taking it a step further, investors can also diversify their exposure across various investment managers. Active investment managers tend to follow distinct strategies, constructing portfolios based on individual asset valuations, expected earnings growth, secular themes, or macro-economic expectations. As can be expected, and already confirmed by many studies, these different investment strategies generate returns that are, on average, uncorrelated with one another. This creates an opportunity for investors to diversify some portfolio risk without necessarily lowering their return expectations. Fortunately for investors, investment experts at Efficient can assist investors who do not feel comfortable constructing their own investment portfolios. A financial advisor can help you to assess your risk tolerance, develop an investment plan, and choose appropriate diversified investments for your portfolio so that you can achieve your long-term financial goals.

Shortly after the turn of the century, following the Asian financial crisis in 1997-1998 and the dot-com bubble burst in 2000-2002, investor sentiment swung increasingly in favour of emerging markets. China was the main driving force, growing at an average rate of about 10% annually between 1990 and 2000, and almost reaching an 11% annual growth rate between 2001 and 2007-2008. But other emerging economies, like India, also played an important role. Overall, between 2000 and 2007-2008, emerging countries were supported by strong economic activity, globalisation and trade liberalisation, commodity booms, financial market reforms, low interest rates, and a demographic dividend, which caused investors to pour capital into their markets. In 2008, with the start of the global financial crisis, everything changed, and the rich world experienced almost 12 years of unprecedented growth, returns, and positive sentiment.

After the mentioned crises, investors were scared and pulled their liquid assets from the risky havens of emerging markets, which not only weighed on emerging market currencies but also on their capital markets. At the same time, the rich (developed) countries started the largest monetary stimulus that the world had ever seen, something emerging countries were not able to do. Not only that, but most of the rich world governments stepped in with fiscal stimulus too, which was also not something emerging markets could do. The result was that investor sentiment swung increasingly in favour of the developed world, and their capital markets and currencies enjoyed unparalleled inflows and returns. Of all the developed countries no one was favoured more than the United States. Not only did they own the global reserve currency but they also had the most sought-after listed companies (technology companies that had free cash flow and needed almost no physical assets), and their risk- and inflation-adjusted bond returns were often the highest in the world.

In 2020, ripe for another global recession which could have shifted sentiment back to emerging countries, COVID-19 intervened. Once again, it was the rich world with almost unlimited supplies of monetary and fiscal support that came out on top. Put differently, rich countries have been keeping their markets alive for longer. But also artificially inflated for almost 15 years. All the while governments in many emerging countries, who cannot print unlimited amounts of money and artificially inflate their markets, have been fighting to enforce structural reforms. Companies in these poor countries have been persistently producing profits without seeing it reflected in their valuations. Investors were simply unwilling to invest in emerging markets whilst enjoying artificially inflated returns in the developed markets that were perceived to be less risky. In this context, it is easier to understand why we have not seen the rand appreciate or the Johannesburg Stock Exchange take flight as it did decades before the 2007-2008 global financial crisis.

But even before the global financial crisis, this swing in sentiment between the emerging world and the rich world has occurred many times over and will continue to do so in the future. It is, however, worthwhile to consider that the length of the cycles might have changed. For this reason, we still maintain that as the rich world is weaned from its stimulants, the rich world will slow down and returns will normalise. In the end, and it can be another five to ten years, sentiment will be forced towards the riskier havens of emerging markets. This, in turn, will result in a substantial appreciation of emerging market currencies and unprecedented returns on their capital markets; the annual double-digit returns we last had before the 2007-2008 global financial crisis.