It’s a tenet of investing drilled into first-year business students: A diversified portfolio offers lower risk and higher returns than investing in single assets, as Investopedia explains. After all, the likelihood that several unrelated types of assets will move in the same direction at the same time historically has been pretty low. That’s why many corporate treasurers must follow a diversification strategy that’s laid out in their company’s investment policy.
However, investors â€“ whether individuals or companies â€“ can’t assume that adding new instruments to their portfolios automatically mitigates risk, says Lance Pan, CFA, and director of investment research with Capital Advisors Group, in Newton, Mass. Pan also is the author of a recent white paper, “Prudent Risk Diversification.”
Of course, adding securities with poor credit quality actually increases risk. What’s more, maneuvering through the risk-return trade-off has become particularly tricky within the pool of available short-term investments. That’s because some securities’ potential for default may overshadow any uptick in yield they provide, Pan adds.
Several types of short-term investments that gained popularity over the past several years may not be as benign as they first appear. Among them: sovereign guarantors. As most of the world economy was crashing in 2008, many governments rushed in to support their countries’ banking institutions. In the process, they essentially created a sovereign-guaranteed bond market, similar to the FDIC bond guarantee program in the U.S., Pan says. However, the troubles in Greece and some of its neighbors have led to “a buyers’ strike on bonds of most southern European sovereign borrowers.”
Similarly, the short-term municipal bond market also is facing pressure. Many cities face climbing liabilities just as their tax revenues are dropping. The result? Investors now are demanding yields that top those on taxable investments. “It’s an indication of investor psychology,” Pan says.
As a supposedly safe investment alternative, some investors have turned to simple bank deposits. Even here, some credit analysis is in order, Pan says. Most banks already have opted out of the FDIC’s Transaction Account Guarantee program, which provided full insurance coverage, no matter the balance, on qualifying accounts. So, companies that hold deposits at a single bank above the $250,000 that’s backed by the FDIC are taking on the credit risk of the banks themselves. That’s of particular concern at regional banks, many of which have been hit hard by the upheaval in real estate.
The upshot? While diversification still remains valuable, it has to be combined with credit analysis. “Each and every new credit is a new source of risk,” Pan notes. What’s more, when the pool of credit-worthy options has shrunk, as is the case currently, particularly when it comes to short-term investments, companies often are better off increasing their concentration in higher-quality credits, rather than simply adding securities for the sake of diversification. ###
By Karen Kroll