Lombard Odier Experts Explain Why Effective Portfolio Diversification Matters
Lombard Odier experts discuss portfolio diversification, drawing on Harry Markowitz's Nobel-winning principles to navigate market shocks, control risk, and manage asset correlations effectively.
Michael Strobaek, global chief investment officer, and Clement Dumar, portfolio manager at Swiss private bank Lombard Odier, have published an economic review advising investors that effective diversification combines assets that react differently to market shocks.
The Logic of Modern Portfolio Theory
"Why hold an investment portfolio combining several types of asset classes, instead of simply choosing the one that recently generated the highest return? The answer is diversification. However, effective diversification depends on the assets in the portfolio continuing to behave differently from one another and providing distinct benefits over time."
Back in 1952, Harry Markowitz demonstrated that the risk of an investment portfolio is influenced not only by the risk of each individual asset, but also by how assets move relative to one another. Combining assets that do not rise and fall together can reduce the overall risk of the portfolio without altering its expected return. This insight earned Markowitz the Nobel Prize in Economics in 1990.
In practice, the picture is more complex. When Markowitz had to decide how to invest his own retirement savings, he did not use the mathematical model that made him famous. Years later, he explained that he feared two scenarios: missing out on sharp market rallies, or suffering a significant drop while being entirely invested in equities.
Managing Risk and Recovery Periods
Therefore, he initially chose to divide his money equally between stocks and bonds—a portfolio he could stick with even during difficult times. After all, the power of compound interest rewards those who remain invested over the long term, and sometimes the right portfolio is not the one that looks best on paper, but the one the investor can hold during a crisis.
Diversification is meant to improve the journey, not necessarily the final destination: to cushion declines, allow for faster recovery, and protect against the most severe risk—permanent capital loss that neither time nor patience can fix.
Generally, higher returns involve higher risks. Although there have been instances where skilled hedge fund managers achieved stock-like returns with milder drawdowns akin to bonds, over more than two decades individual asset classes and markets failed to achieve this on average. A balanced portfolio is subject to the same risk-return trade-off, but spreads risk across multiple channels rather than depending on a single asset or market.
Dynamic Asset Allocation
People sometimes underestimate the importance of limiting losses. A portfolio that drops by 50% must subsequently rise by 100% just to return to its starting point. Recovery years are also years when the investor misses out on the compounding effect of returns. A balanced portfolio presents a healthy ratio between long-term returns and the recovery duration from sharp declines.
Diversification is not a static state, because relationships between assets change over time. For instance, between 2001 and 2020 stocks and bonds tended to move in opposite directions, but since 2021 their correlation turned positive again. In 2022, as inflation and interest rates surged sharply, both asset classes declined simultaneously, serving as a reminder that relying on a single source of diversification is flawed.
Even a portfolio that appears diversified may actually be exposed to the same underlying factor. Today, for instance, artificial intelligence impacts not only tech stocks, but also credit, private financing, and commodities such as copper. Therefore, the goal is not to avoid exposure to a specific sector, but to understand how dependent the portfolio is on it and manage that exposure accordingly.
In conclusion, a diversified portfolio requires ongoing management: monitoring risks and opportunities, rebalancing exposures when conditions change, and ensuring that diversification is maintained. Even good assets on their own do not necessarily create a good portfolio—what matters is how they combine with one another.
