U.S. equities drove stock market returns in 2024, with the effect amplified for Canadian investors as the loonie weakened against the U.S. dollar. But lift the hood and it quickly becomes apparent that a handful of stocks — the Magnificent Seven — had an outsized effect on U.S. equity performance. That overconcentration poses risks for investors in 2025, as do stocks priced to perfection and geopolitical risks that could negatively affect investor sentiment.

In a potentially volatile environment, advisors know that optimizing diversification is more important than ever to minimize concentration risk and maximize returns. But what’s the best way to go about achieving that when even broad market indexes are disproportionately affected by the rise or fall of just a few companies? To achieve consistently good performance, it’s critical to go beyond regular rebalancing and look for different, deeper ways to achieve diversification.

At NEI Investments, Judith Chan and her team have developed a multi-step, multi-layered approach to diversification that regularly refreshes market assumptions and return expectations to assess which areas of the market are most attractive in future risk-adjusted returns. Chan, NEI Investments’ Vice-president and Head of Asset Allocation describes what she does, on a regular basis, as “re-optimization.”

Unlike regular rebalancing, re-optimization is a process to re-constitute the portfolio using the most updated market assumptions, aiming to identify and include the most attractive opportunities in the portfolios, while paying close attention to risks that can undermine the team’s efforts.

“Even the stock-bond correlation can change quickly, and that would give us a different mindset or a different opportunity in a multi-asset setup,” says Chan. “For us, it’s the relationship and the relative attractiveness between asset classes that impact us most.”

Finding the right balance for uncertain times

Investors need to be prepared for the possibility that markets will experience volatility in the coming months, Chan says. With U.S. equities in particular trading at high prices, and starting valuation being a very strong indicator of future total returns, it’s critical to be mindful of risk.

“We want to be a little bit more conservative and more defensive. We’re looking for opportunities to be able to capitalize on the downside. If we get market volatility, we want instruments or building blocks where we can build in that offset, to provide downside protection more than ever.”

In this context, Chan suggests that portfolios may benefit from holding alternatives, derivatives, real assets, and instruments with built-in downside hedging. At the same time, she emphasizes, it’s important not to be “too fearful” and pay too high an opportunity cost.

Finding the right balance in any market environment is what optimized diversification is all about — and, again, Chan believes it’s essential to continuously monitor and fine-tune that balance as conditions, and market environment changes quickly. There’s a need to cultivate agility — an ability to anticipate changes and promptly make appropriate adjustments.

“Even though we assess our long-term assumptions on an annual basis, we also have tactical shorter-term signals that give us a more agile look at the market. If the assumptions are changing, or if market dislocation gets extreme, we can make changes in our portfolios with more conviction,” she says.

In the face of current pressures on markets, Chan emphasizes it’s vital for advisors to look for ways to neutralize unintended tilts to ensure the portfolios their clients hold can continue to perform whatever surprises markets throw our way. One way NEI manages this challenge is to make use of a wide range of building blocks within portfolios. Recently, the team has broadened the building blocks at its disposal – for example, by adding more exchange-traded funds and a long-short equity fund to the menu.

The NEI team has also invested in human expertise and added technological tools, including leveraging predictive market modelling using AI technology such as machine learning to enhance the portfolio construction process, in order to position portfolios for the next 10 years. People and technology working together enables a new level of precision – what Chan calls having “fingertips on the pulse of the markets and our funds” – and generate fresh insights into the makeup of each portfolio.

Accessing predictive models that respond to real-time analytics can help advisors steer clients through inevitable ups and downs over the next decade and more. To learn more about how NEI’s investment team identifies, capitalizes on and monitors underestimated investment opportunities using a rigorous investment process, reach out to the NEI Sales team today or visit their website for more information.