Investment Masterclass – Diversification: The Free Lunch of Investing

Ian King, Monday February 10, 2014

I have discussed in previous posts some of the basic concepts concerning investment risk and indicated that a lot of the risks associated with investment can be controlled or even eliminated.

Diversification

Whilst risk will always remain, principally short-term volatility risk and/or inflation risk, most other risks (stock, interest rate, exchange rate etc) can be alleviated by employing a strategy of diversification.

What and how?

What is diversification and how do you go about achieving it?  In its simplest form, diversification is the adherence to the old phrase of “not putting all of your eggs in one basket”.  Otherwise put, do not concentrate your investment strategy in too few opportunities.

Diversify Investment

One can diversify an investment strategy in many ways:

  • Asset class: A mix of a combination of shares, bonds, cash, property and other assets will for most investors be more suitable than a portfolio constructed from one class.
  • Geography: Don’t have your whole portfolio invested in UK focused, and Sterling denominated assets.  Investors all over the world have a “home bias” to their strategies, but there is no rhyme or reason why this should be the case.
  • Market capitalisation: Don’t have all your strategy invested in, say, larger companies.  Smaller and medium sized companies can offer just as good if not better returns whilst spreading your risk.
  • Concentration: Your portfolio shouldn’t be invested in a limited number of funds or companies.  Most collective investment portfolios of any size should have around ten funds within the portfolio.  A portfolio of individual shares needs at least twenty stocks to achieve any decent degree of diversification.  Care here is needed – adding ten more funds to a forty fund portfolio is not likely to significantly improve diversification!

Investment Strategy

The great benefit of diversification is that it can be used to significantly reduce volatility in returns but does not systematically work to reduce returns.  Modern Portfolio theory, as pioneered by Harry Markowitz in 1952, dictates that investors can act to reduce portfolio volatility by incorporating investment opportunities whose future returns were not set to be perfectly correlated with each other. Ideally, you would include assets which were negatively correlated, i.e. the value of one would increase at the same time as the other was falling.

Modern Portfolio Theory has however shown that it is possible to reduce portfolio volatility by incorporating assets together who have a positive correlation, just so long as the correlation is not perfect. In other words both assets can rise (or fall) at the same time but so long as they are not of the same magnitude, diversification can be achieved.

The theory continues that you could be able to combine two assets together with identical expected returns (but different volatility expectations) and so long as the assets returns were not perfectly correlated with each other you would be able to achieve the same overall return with any combination of the assets and yet potentially reduce volatility to a level below that which you would be subject to if you held just one of the assets.  In essence this is diversification in its simplest form – we just extend the practice to hold numerous different investment opportunities.

Whilst any theory can be developed, and of course continues to maintain its critics, the process of diversification has been at the centre of any well-constructed portfolio for the last fifty years.  

Over this time investors have been receiving something (reduced risk) for nothing (no expectation of reduction in long-term return).  Hence, this is why diversification is known as “the one free lunch of investing”.

Portfolio

How is your portfolio arranged? Are you tucking in to your free lunch?  If you are being advised upon your portfolio and you do not have sufficient diversification you need to ask why!

As always, we welcome your comments.

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2 Comments

  • Hello there! Do you use Twitter? I’d like to follow you if that would be okay.
    I’m definitely enjoying your blog and look forward to
    new updates.

  • Ian King says:

    Hi,

    Yes we are on Twitter @family_legacyUK

    Thanks for getting in touch and we are please that you are enjoying our posts!

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