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Most self-directed investors are well-versed in the art of sector diversification—spreading investments across different industries to mitigate risks associated with market volatility. This traditional approach aims to reduce the impact of a downturn in any single sector by balancing it with investments in others. While this method has its merits and has been a cornerstone of investment strategy for decades, it often overlooks the broader picture of your total financial exposure.
While many investors understand the natural correlations between major companies, sectors, and their respective indices (think the big four Aussie banks and the XJO), the less obvious ones can be just as impactful. For example, the below shows the very high correlation between Commonwealth Bank Australia (ASX:CBA) and Goldman Sachs (GS), with the Australian index for perspective:
In today’s increasingly interconnected global economy, relying solely on sector diversification within an equity portfolio might not provide the comprehensive risk management you need. Market correlations have increased, and events in one sector can quickly ripple across others. That’s where exposure allocation steps in—a strategy that evaluates risks across your entire financial landscape, not just your share portfolio.
What Is Exposure Allocation?
Exposure allocation is about looking at the bigger picture of your finances and understanding how all the pieces fit together. This includes shares, bonds, property, commodities, cash holdings, business interests, and even personal debt obligations. The goal is to balance risks and returns across these areas rather than focusing solely on diversifying your equities.
For instance, let’s say you own a property development business. Your share portfolio might look diversified, holding a mix of technology, healthcare, and consumer goods stocks. But if it’s also heavily invested in real estate investment trusts (REITs) or construction companies, you’re amplifying your exposure to the property market. A downturn in real estate could simultaneously impact your business and investments, leading to compounded losses.
The Limitations of Sector Diversification
Sector diversification assumes that industries perform independently, reducing overall portfolio risk. But this assumption doesn’t always hold. Several limitations arise with this approach:
- Increased Market Correlations: In times of global events or economic stress, uncorrelated sectors often move in tandem. The 2008 financial crisis is a prime example, with declines in the housing market affecting banking, insurance, and commodity prices.
- Overlapping Sector Exposures: Companies often span multiple sectors, blurring diversification. A conglomerate classified under industrials might also have significant technology or healthcare interests.
- Ignoring External Financial Factors: Sector-based strategies focus narrowly on your equities, ignoring other commitments like property ownership, personal loans, or pension plans. These can significantly influence your overall financial risk.
- Global Economic Influences: Events in one country or sector often have worldwide ripple effects. A trade dispute or regulatory change can simultaneously impact multiple sectors and markets.
The Case for Holistic Risk Assessment
Exposure allocation ensures you consider all aspects of your financial situation, helping you manage risks more effectively. Here’s how it works:
- Identifying Overlaps: Recognise how different assets interact. For instance, if you hold global equities, you might already have exposure to emerging markets via international ETFs or pensions.
- Analysing External Risks: Consider factors outside your portfolio, such as property ownership, your employment industry, or debt obligations. If you work in the automotive industry, for instance, economic downturns could affect your job and should influence investment decisions.
- Implementing Complementary Strategies: Allocate assets to counterbalance external risks. If you’re heavily invested in property, reducing REITs and focusing on sectors like healthcare or utilities could help diversify.
- Assessing Liquidity Needs: Understand how much liquidity you require. If you’re nearing retirement, you may prioritise income-generating and easily sellable assets.
- Considering Tax Implications: Different assets have varying tax treatments, which can affect your net returns. A holistic view helps optimise your financial outcomes.
Putting Theory Into Practice
Imagine you work as a senior executive in the energy sector, specifically in oil and gas. Traditional investment advice might suggest diversifying into technology, healthcare, and consumer staples stocks. But exposure allocation takes a broader view. Since your primary income depends on the energy sector, a downturn in oil prices could affect your job and the value of energy stocks. Exposure allocation would recommend reducing investments in energy and focusing on sectors like renewables, technology, or international markets with different drivers. Diversifying into bonds or precious metals could provide further protection.
Or consider an investor with significant real estate assets. A traditional approach might overlook the overlap between property holdings and real estate-related equities. Exposure allocation, on the other hand, could recommend reducing property stocks and increasing exposure to less correlated sectors, such as healthcare or technology.
Final Thoughts
Exposure allocation builds on the principles of diversification by integrating your broader financial reality into your investment strategy. It doesn’t discard sector diversification but enhances it by addressing the unique risks you face.
By thinking holistically, you can better protect yourself from unexpected risks while maximising opportunities across all areas of your finances. As global markets grow increasingly interconnected, exposure allocation offers a sophisticated framework for managing today’s complex financial landscape.