We explore the fundamental components of diversification and the key elements to consider in planning and building a well-constructed diversified portfolio.
When it comes to investing, “diversification is the only free lunch”, economist and Nobel Prize laureate Harry Markowitz famously said.
What Markowitz meant was that diversification is the only investment strategy guaranteed to reduce risk and improve long-term performance.
Ray Dalio, founder of hedge fund giant, Bridgewater Associates, put it another way in his best-selling book, Principles.
According to Dalio, diversification is the “Holy Grail of Investing” and, done the right way, can increase a portfolio’s return-to-risk ratio by a factor of five and reduce risk by 70% to 80%.
And both men know a thing or two about investing.
Dalio’s Bridgewater Associates manages USD123.5 billion and has made more money for its investors than any other hedge fund in history. It is the fifth most important company in the United States, according to Fortune magazine.
Markowitz, referred to as the father of Modern Portfolio Theory, revolutionised how money is invested. Based on his theory, the performance of a single asset is not as important as the performance and composition of an investor’s entire portfolio.
But is there such a thing as too much diversification? What is the optimal number of assets to hold in a portfolio?
Focusing purely on Australian equities, it is largely accepted that a portfolio of 20-30 stocks, spread across sectors and industries, provides adequate diversification.
Beyond that number, the benefits of diversification start to reduce, says Andrew Doherty, Managing Director of AssureInvest; a specialist asset consultant that partners with financial advisers to build model portfolios and managed accounts.
Contrary to the view that a larger number of holdings provides greater diversification, Doherty argues that a highly concentrated portfolio can be less risky because it represents a professional investors’ best ideas.
“Portfolios should represent an adviser’s high conviction ideas. If you research thoroughly, do your homework and really get to understand a business, you should take a bigger position in the companies you really like,” he says.
“Over-diversification can occur when an investor lacks conviction and spreads a portfolio thinly across lower conviction ideas. As a result, returns can be diluted by small holdings in lower quality assets.”
First and foremost, advisers should focus on finding high quality businesses that are attractively priced. Diversification is critically important but it’s a secondary consideration, Doherty says.
The key to diversification
The key to effective diversification does not lie in a number but rather selecting assets that are lowly correlated, uncorrelated or negatively correlated. Therefore, when parts of a portfolio fall, others rise. This not only reduces overall risk, it can improve returns, especially during periods of high market volatility.
Historically, equities and bonds have been used as examples of asset classes that are uncorrelated or lowly correlated.
When it comes to equities, an example of two sectors that are largely uncorrelated are oil and gas companies and airlines because airlines benefit from cheap fuel but typically underperform when oil prices are high.
A well-diversified portfolio should give investors exposure to different risk and return factors including different market segments, different demand factors and different stages of the business cycle.
All that said, Doherty says it is okay for advisers to build portfolios with little or no exposure to a particular sector or industry, if they have a strong conviction, based on research.
Conviction works both ways.
Ideally, advisers should follow robust portfolio construction principles and guidelines.
Too much of a good thing
In the same way, companies develop and offer multiple product lines, operate in various channels and countries, and buy different assets in order to pursue multiple opportunities, diversify their revenue and reduce their reliance on a single source of return, investors should hold a balanced collection of stocks to derive returns from many potential sources and reduce overall risk and volatility.
However, just like in business, owning too many assets can be detrimental to performance by adding complexity, increasing costs and spreading a company’s limited resources too thinly across a number of bets.
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