Key takeaway
Most of us insure our homes even though they are unlikely to burn down. We accept a small, predictable cost to protect against a large, disruptive loss. We do not expect insurance to increase the value of our house. We expect it to reduce the financial damage if something goes wrong.
Investing works in a similar way. In expensive markets, reducing equity exposure may slightly limit upside in strong periods, but it can materially reduce losses when markets fall. Over the past three years, a balanced portfolio captured a meaningful share of equity gains while experiencing far lower volatility and significantly smaller drawdowns.
Large losses are costly because they require disproportionately strong gains to recover. Avoiding deep setbacks improves the ability to compound over time.
Diversification is not about being cautious for its own sake. It is about ensuring that portfolios can participate in rising markets while remaining resilient when conditions change.
This article continues our series examining diversification and how risk is defined in modern portfolio construction.
In the first article of this series, Beyond the equity lens — Diversification still matters, diversification was framed not as a tool for maximising returns, but as a mechanism for reshaping the distribution of outcomes. Credit was described not as a volatility dampener, but as structural capital protection: altering drawdown dynamics, improving cashflow visibility and preserving reinvestment optionality when markets reprice risk.
Today, equity valuations are elevated, market breadth is narrow and risk appetite remains strong. In such regimes, diversification is often interpreted as dilution — as if reducing equity exposure mechanically implies surrendering return potential.
But if credit reshapes outcomes rather than simply lowering volatility, the relevant question shifts from “How much return are you giving up?” to “What kind of return distribution are you buying”.
The cost and surprise of reducing risk
Between February 2023 and February 2026, a popular low-cost global equity index fund delivered a total return of 41.8% in SEK, net of fees. Over the same period, our Espiria 30 fund, a 30/70 balanced portfolio, returned 23.5% in SEK, net of fees.
Viewed superficially, this appears to validate the conventional logic: lower equity exposure, lower return. Yet this framing ignores the structure of risk taken to generate those returns.
The equity allocation operated with an annualised volatility of 14.38%, compared with 4.35% for the balanced portfolio, roughly one-third of the risk. Maximum drawdown reached –24.2% for equities, while the balanced portfolio declined by –8.8%. A 24% decline requires approximately a 32% gain to recover, whereas a 9% decline requires roughly 10%.
Crucially, the equity fund remains in a recovery phase and has not yet returned to its previous peak. The balanced portfolio recovered materially faster and re-established prior highs within a significantly shorter timeframe. Time under water is not merely a performance statistic, it is a constraint on capital flexibility, behavioural discipline and reinvestment optionality.
Despite holding approximately 30% equities, the balanced portfolio captured 56% of the equity market’s average daily return. Risk-adjusted performance, measured by the three-year Sharpe ratio, was higher in the balanced allocation (0.85 versus 0.77). Lower volatility was not purchased at the expense of capital efficiency.
In an expensive market, the relevant question is not how much absolute return is forgone by reducing exposure, but how much downside asymmetry is mitigated. The evidence suggests the cost of lowering risk has been materially lower than assumed, while the structural benefit, in volatility compression and drawdown control, has been significant.
Why correlations and downside dynamics matter
As discussed in part one of this series, diversification within equities works best when markets rise. It works worst when markets fall.
A consistent finding in financial research is that correlations increase during drawdowns. Stocks may behave independently in benign conditions, but in stress regimes they tend to move together.
Downside correlations are structurally higher than upside correlations. When markets reprice risk, diversification across equities alone offers less protection than expected. This asymmetry matters more in expensive markets. When valuations are elevated and market breadth is narrow, portfolios become implicitly dependent on a small set of drivers. If those drivers weaken, co-movement accelerates. Declines are typically faster than advances. Correlations rise when volatility spikes. Recovery requires disproportionate gains.
In that environment, relying solely on intra-equity diversification is insufficient. Cross-asset diversification, combining equities with fixed income and other lower volatility exposures, addresses precisely the regime in which equity diversification becomes least effective. Diversification does not fail during market stress; equity-only diversification does
Figure 1: Espiria 30 - Three-Year Drawdown
Risk is a spectrum
The allocation decision is not binary. A 30/70 structure represents only one point on a continuum. For investors seeking lower risk than full equity exposure but higher risk than Espiria 30, the balance between equities and credits can be adjusted. Intermediate risk alternatives
therefore exist:
These strategies allow calibrated positioning along the risk spectrum, adjusting participation and protection without committing to concentration or full defensiveness.
The relevant decision is not whether to own equities, but how much valuation risk and drawdown asymmetry one is willing to carry at current pricing levels.
Discipline in comfortable markets
Expensive markets tend to reward conviction and penalise caution, until conditions change. Correlations rise in stress. Drawdowns accelerate. Recovery requires disproportionate
gains.
Diversification should not be evaluated by how closely it tracks concentrated equity performance during favourable regimes. It should be judged by how effectively it preserves capital efficiency across cycles.
The experience of the past three years demonstrates something structurally important: reducing equity exposure has not required a proportional sacrifice in return. Participation has been meaningfully higher than intuition might suggest, while volatility and drawdown asymmetry have been materially lower.
This is precisely what diversification is designed to achieve. In expensive markets, diversification is not conservatism, it is discipline.
Important information: This is marketing communication. Investment in funds always involves some kind of risk. Past performance is no guarantee for future performance. Fund units may go up or down in value and investors may not get back the amount invested. This information shall not be regarded as an offer, solicitation or recommendation for an investment. Efforts have been made to ensure the accuracy of the information in this document, but it cannot be ruled out that it is based on unaudited or unverified figures and sources. This publication is not directed at you if we are prohibited by any law in any jurisdiction from making this information available to you and is not intended for any use that would be contrary to local laws or regulations. Access to our funds may be limited in some countries. Full information such as the prospectus, key investor information documents, articles of incorporation and annual reports, can be obtained on the fund page and from all the local representatives or information agents, or our distributors.
