How to Diversify Your Portfolio: Lessons From Two Market Crises

When markets fell in 2022 and during the Iran crisis, bonds failed to protect investors while infrastructure and commodities held firm in both. The lesson for ordinary investors is clear: relying on a traditional stocks-and-bonds portfolio may not be enough. Diversifying into real assets could make your portfolio more resilient, whatever the next crisis brings.

The ultimate outcome of the war in Iran remains uncertain, but the more vulnerable areas of global financial markets are becoming clear. In the early stages of the crisis, volatility was broad-based, but investors are now being more discerning. What lessons, if any, can be learned? And are they the same lessons that the 2022 energy crisis revealed?

To date, the impact on stock markets has been far less significant than in 2022. After an initial sell-off, most of the traditional ‘risk on’ sectors – technology, emerging markets, global smaller companies – have bounced back. Investors have instead sought to focus on specific areas of weakness. India, for example, has been the worst-performing IA sector for the year to date, with the average fund down 11.8%. Investors have worried about its energy supply and its weakening currency, at a time when valuations in the Indian market were already high.

To date, the impact on stock markets has been far less significant than in 2022. After an initial sell-off, most of the traditional ‘risk on’ sectors that investors tend to favour when they have more confidence – technology, emerging markets, global smaller companies – have bounced back. The areas of weakness have been more specific. India, for example, has been the worst-performing IA sector for the year to date, with the average fund down 11.8%. Investors have worried about its energy supply and its weakening currency, at a time when valuations in the Indian market were already high.

Healthcare has historically tended to be a defensive sector and relatively insensitive to the broader economic environment. But it has also been weak since the start of the year, with the average fund falling 2.3%. It has had a range of idiosyncratic problems, mostly around policies from the US administration. In each case, the weakness has been idiosyncratic, rather than a general disillusionment with markets.

In 2022, the crisis prompted a more broad-based sell off in riskier assets. Funds in the IA technology and technology innovation sector fell 27.5% on average, UK smaller companies funds dropped 25.2%[1], while European smaller companies fell 21.1%. This also affected the shape of the recovery. As risk appetite returned, many of the sectors that fell most in 2022 recovered quickly in 2023. Technology and Technology innovation, for example, jumped 38.9%.

In general, where sectors didn’t recover, it was because structurally higher interest rates were difficult for them to absorb – smaller companies, for example. This time round, the weaker sectors have some structural problems. India, for example, is dependent on imported oil, and the rupee has weakened significantly. This could have a long-term economic impact. Healthcare is still navigating a changing regulatory and policy environment in the US. It is more difficult to see an immediate bounceback for these areas.

However, in both crises, the same sectors have been protective. Infrastructure, for example, has been a strong performer each time. The average fund rose 2.9% in 2022, and is up 9.9% for the year to date. The other obvious area of strength has been in commodities, with funds up 18.8% in 2022 and 15.2% for the year to date. However, investors have had to take the rough with the smooth – in 2023 and 2024, commodities funds delivered a negative return.

Why bonds have struggled to protect investors in both crises

The weakness in bond markets has been common to both crises and should prompt some questions for investors over the efficacy of bonds as a diversifying asset. Bonds still have plenty of reasons for inclusion in a portfolio – they have high yields

, for example, and can offer some defence in a weaker economic climate. If developed economies start to stagnate, with higher inflation and lower growth, bonds may prove to be a stable option for investor capital.

However, in 2022 UK gilt

funds fell an average of 23.9%, and sterling corporate bonds by 16.1%. Over five years, UK gilt funds are still over 20% lower[2]. For the year to date, UK gilt funds have fallen 1.3% and Sterling Corporate Bond funds by 0.1%.

This presents a dilemma for investors. The IMF’s view is that due to structural changes in the market, bonds have become less effective in cushioning volatility

in stocks. Instead of offsetting equity risk, the two asset classes are increasingly correlated, particularly during market sell-offs. It says:

Luca Paolini, chief strategist at Pictet Asset Management, agrees that the current environment merits a significant allocation to alternatives, particularly ‘real’ assets such as property and gold.

How to diversify more effectively in a world of geopolitical uncertainty

What is not in doubt is the need for more effective diversification in many portfolios. The wave of trillion dollar IPOs launched on the US market undoubtedly brings some exciting and unusual companies to investors. However, they all have one thing in common – artificial intelligence. As SpaceX, Anthropic, OpenAI and others are absorbed into the major indices, it is likely to create greater concentration in US and global indices on a singular theme and a handful of companies.

This was already a concern for investors. Those investing in an MSCI World tracker fund or ETF have over 70% in the US, and 31% in technology[4]. While technology has not shown itself to be particularly vulnerable in either crisis, it leaves little room for more diversifying assets. Investors need to be prepared for a range of scenarios and incorporating areas such as infrastructure and commodities can help defend portfolios at times of geopolitical tension and commodity volatility.

Not relying solely on bonds to diversify equity risk is also important. They have not provided adequate protection in inflation-driven shocks. Incorporating gold or real assets can hedge against a broader range of risks.

The current crisis and 2022 are not identical. However, the reaction of bond markets in each crisis should give investors pause for thought. Also, even if different parts of the equity market have sold off, similar assets have proved protective. Lessons from both crises can inform portfolio allocation in the future.

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[1] Trustnet

[2] Trustnet

[3] IMF blog

[4] MSCI