FE Trustnet readers believe it has never been harder to build a cautious and diversified portfolio, with a poll showing that 56 per cent of 1,888 readers think the current environment is the toughest they have ever seen to build such an entity – and it’s easy to see why. 
Certainly, with bonds still offering very little in the way of yield, cash giving you nothing and concerns ramping up in regard to equities, where can investors turn?
Take bonds, for example, which have been an asset class that has tended to provide the core of a cautious or balanced portfolio over the past few decades.
Investors will no doubt know that bonds, both government and corporate, have been through an extended bull run with yields consistently falling thanks firstly to the credit boom prior to the financial crisis and then the extraordinary monetary policies of central banks – such as ultra-low interest rates and quantitative easing – over the past seven or so years.
However, the recent macro uncertainty has left 10-year UK government bonds now yielding just 1.38 per cent – yet inflation seems to reappearing and many expect interest rates to rise here and in the US. Though spreads have widened more recently, corporate bonds are also still very expensive compared to their long-term averages.
As a result, many have advocated that investors turn increasingly to equities within their portfolios. But, following some stellar gains since the global financial crisis – again helped by central bank stimulus – concerns are on the rise within the asset class thanks to various macroeconomic headwinds and high valuations in certain areas.
Therefore, many now believe that the traditional approach to asset allocation – especially for cautious investors – will no longer work.
Though investors will have had different experiences over the years, one way they could have built a diversified cautious portfolio in the past was by holding 50 per cent in government bonds, 25 per cent in equities, 20 per cent in investment grade corporate bonds and 5 per cent in cash.
Performance of a traditional cautious portfolio over 25yrs
Source: FE Analytics
As the graph above shows, that traditional asset allocation mix has delivered a high 363.97 per cent return over 25 years but with a maximum drawdown – which highlights the most an investor would have lost if they had bought and sold at the worst possible times – of just 15.37 per cent.
On top of that, investors in such a portfolio would have seen a positive return in 21 of the last 25 years. Out of those 21 years, they would have seen a double-digit gain in just under half of them.
The main reason why that blend has worked so well over the years is because bond and equity returns have been inversely correlated, with equities powering forward during more positive environment and fixed income assets picking up the slack when sentiment has fallen.
However, many believe that the recent policies of central banks and the subsequent high valuations in bond markets mean correlations will only increase from here.
Indeed, we have seen signs of this over the recent past. For example, FE data shows gilts and the UK equity market have had a negative correlation of -0.10 over 20 years, but between April and August last year the correlation between the two ramped up to 0.8 as equities fell from their highs and investors started selling bonds en masse.
Performance of indices between April and August 2015
Source: FE Analytics
Though that was a very short period time, there is little surprise that some argue as bond and equity valuations have both been inflated by QE and low rates, prices will fall in tandem if those policies start to reverse.
So, starting with a blank canvas, do industry professionals agree with FE Trustnet readers that it has never been harder to build a cautious diversified portfolio? 
“I definitely agree with the readers,” Ben Conway, fund manager at Hawksmoor, said.
“It keeps getting harder. Generally speaking cautious portfolios are easier to build the more cheap assets there are: risk is directly proportional to valuation. Unfortunately most liquid mainstream risk assets are expensive.”
“Mainstream equites are certainly no longer cheap – some are outright expensive. Government bonds are no longer diversifying assets and most offer a guarantee of a negative return. Consider UK index-linked bonds – most of which guarantee a real negative yield – meaning that a buyer of or investor in these bonds today is hoping someone else will buy them when they yield an even greater negative real number. Incredible.”
Conway points out that while opportunities have opened up in high yield bonds, he questions how many ‘cautious’ investors would want exposure to an asset class which is often referred to as ‘junk’.
This could also be said for other ‘alternative’ asset classes, though it could be argued many cautious investors wouldn’t want to own less mainstream assets where they might be given up liquidity.
Peter Elston, chief investment officer at Seneca, said: “From my own experiences, I would have to say ‘yes, this is the most difficult environment I’ve known’.”
Elston doesn’t, however, agree with the view that equities are expensive and says investors can afford to hold more in risk assets for the longer term given the higher than average yields on offer around the world.
Indices’ current dividend yields and average dividend yields over 15yrs
Source: MSCI
“You can still find good value in equities, but when it comes to one of the building blocks of a standard cautious portfolios – bonds – that’s where the real problem lies,” Elston added.
“There is a genuine lack of value in fixed income. If you were to buy a 30-year index-linked gilt today, you are guaranteed to lose 25 per cent of your real capital. But, if you had bought a 30-year gilt 30 years ago, you would have seen a return of more than 400 per cent.”
“There has been a real change and investors need to realise that.”
Of course, it must be noted that government bonds have regained their safe haven status more recently, as China’s macro uncertainty, falling commodity prices and a general loss of faith in central bankers’ abilities caused yields to rally at the start of the year while equity markets tumbled.
Performance of indices in 2016
Source: FE Analytics
As such, FE Alpha Manager ‘hall of famer’ Robin Hepworth, who has run his Edentree Higher Income fund since 1994, doesn’t believe now is the most difficult environment he has ever seen to build a cautious diversified portfolio.
“I think it is a very difficult time indeed, but I think every year for the past 25 years I’ve thought the same thing. For me, I’m fairly comfortable that the sort of areas I’m weighted towards still offer reasonable value,” Hepworth said.
However, Hepworth holds nothing in government bonds and little in traditional corporate bonds and this is where Elston says the real difficulties lie today.
The idea for this poll came from conversations between members of the FE Trustnet team and various financial advisers, with many of them arguing that not only is it an incredibly difficult time to build a diversified portfolio, but that it is even more difficult to communicate to their clients why they may need to change their holdings or expectations.
Elston points out that the last 30 years of falling bond yields have made many retail investors believe that fixed income will continue to deliver very high returns with low volatility in the future.
He says that hasn’t always been the case and simply won’t be the case anymore with current yield levels and therefore says the main way in which investors can generate a diversified portfolio is by gaining a better understanding of risk.
“It’s an extremely important point,” Elston said.
“I have said in the past that building a portfolio using a value-orientated approach isn’t necessarily going to lower your short-term volatility, but it will limit your chances of longer term real loss of capital.”
“It’s all about how you define risk. If you think risk is volatility, go and buy a 10-year government bond with a real yield of less than 0 per cent. If you view risk as the permanent loss of capital, don’t touch them with a barge poll.”
Following on with the poll and due to clear uncertainty among FE Trustnet readers, all the articles this morning will be dedicated to portfolio diversification.
We will take a closer look at how the experts build a cautious portfolio, which asset allocation is the best for a cautious investor and some of the funds they may wish to consider within their portfolios and look through some of the best one-stop-shop multi asset funds for cautious investors who want asset allocation decisions made for them.