Investors searching for yield in this environment of falling interest rates can be tempted to head down a risky path which overlooks the basic rules of diversification.

The importance of an adviser’s role in assessing their client’s specific needs and crafting a diversified portfolio that can support sustainable spending is crucial.

Vanguard’s research paper ‘Desperately Seeking Yield’ highlights a number of examples that illustrate the dangers of pursuing yield in individual assets without considering the various risks.

The research shows that diversified income generated by Australian equities plays an important role in most portfolios particularly as equity investments also provide the opportunity for growth. However to offset the systematic risk which equities generate, including other asset classes such as fixed income to moderate the volatility can be beneficial – this is demonstrated by the table below showing the diverse profiles of various income generating asset classes.

Lower yields from traditional fixed income investments have prompted some investors to over-concentrate a portfolio on a small set of assets or select assets with promises of fixed income like outcomes, however these tactics have inherent risks.

One example is hybrid securities which are marketed with yields superior to common debt offerings, however, in times of market stress issuers have exercised the flexibility of non-uniform terms to vary or cease coupon payments entirely.
The major shortcoming of focusing exclusively on yield from one asset class is material as it undervalues the importance of diversification in portfolios. Such a strategy can also challenge a portfolio’s liquidity and the sustainability of the yield itself.

Focusing instead on a ‘total return’ approach, which encompasses both income and capital return components, can serve to maintain portfolio diversification and increase the longevity of the portfolio.

In the scenario where outgoings exceed income, drawing from capital appreciation of the portfolio rather than sacrificing diversification and over-weighting higher yielding sectors of the market can improve portfolio longevity.

Even in situations where yield is a high priority, portfolio construction should still adhere to fundamental asset allocation principles, investors would be better served not chasing the prevailing yield of the day, but seeking diversified income streams by focusing on total returns.

Whether investors are early in their investing life or drawing on a portfolio in retirement, the opportunity exists for advisers to offer value through assisting clients to understand the value of diversification in building long-term strategic portfolios.

If you would like to read more on this topic you can click here to view Vanguard’s research paper.

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