Diversification: The Investor’s ‘Free Lunch’
Investment diversification is typically explained as “not having all your eggs in one basket”. Spreading your investments across diverse assets affords exposure to higher-risk assets while decreasing the overall risk of your portfolio.
American investment icon Warren Buffet is regarded as being anti-diversification. He has argued in favour of investing in a low number of carefully selected, high-quality stocks in which you have a high conviction. One must not forget, however, that Buffett’s utterances on investing have mostly come from the celebrated annual meetings of his company, Berkshire Hathaway, in Omaha, Nebraska, which attract investment professionals from all over the world. This advice was not directed at consumers.
For the purposes of the lay investor whose aimis to build wealth over the long term, there are few investment experts or financial planners who would not advocate diversification – they commonly refer to it as a “free lunch”. By that they mean that you can benefit from the superior returns that typically come from stock-market investments while tempering the risks associated with them.
If applied correctly, diversification smooths out the volatility of a portfolio by offsetting negatively performing investments with positively performing ones. This means that the strategy only benefits you if the assets in your portfolio are uncorrelated – in other words, that they behave differently, often in opposing ways, in different market situations. There are zero benefits if all the assets in the portfolio move in the same way all the time. In a well-diversified portfolio, scanning through the returns of the underlying investments, you should expect to see some investments performing better than others at any given moment and possibly even some in the red.
But you can also over-diversify. In a roulette game, if you offset the risk of a bet on red with an equal bet on black, you win nothing. Thus while diversification reduces risk, it shouldn’t eliminate it.
The two main ways you can diversify your portfolio are across asset classes and across geographical regions. You can also be diversified within asset classes and regions.
Asset class diversification
Bonds and equities tend to behave differently. Equities rise in periods of economic growth. When markets become overheated, central banks normally step in to dampen growth by raising interest rates, which deflates bond prices. The opposite occurs when the economy falters. Central banks lower rates to stimulate business activity, causing bond prices to rise. It therefore makes sense to “hedge” against recessions by having exposure to bonds.
Within both the bond and equity markets, there is also scope to diversify. In equities, there is variability in return patterns among different industrial sectors and between small- and large-cap shares. In the bond market you can diversify between shorter- and longer-term bonds and between government and corporate bonds.
Other asset classes that you may consider for diversification include cash instruments, property, commodities such as gold, and alternatives such as private equity and cryptocurrencies.
Regional diversification
Offshore investing offers diversification through a greater choice of investments, including in sectors that are not well represented in South Africa, as well as through spreading risk across different economies. For example, the South African, US and Japanese economies may not behave in the same way in a given situation and are exposed to different geopolitical risks. There are also diversification benefits across developed and emerging economies. When investing overseas, however, there is an additional risk that must be acknowledged and managed – that of exchange-rate volatility.
Collective investment schemes
By their nature, collective investment schemes (CISs) such as unit trusts and exchange-traded funds (ETFs) are invested in dozens of underlying securities, providing substantial diversification. This may be within an asset class, such as in an equity fund, or across asset classes, as in a multi-asset fund.
For a well-diversified CIS portfolio, it’s a good idea to look at one’s overall allocations to different asset classes and regions. You may also consider diversifying between active and passive funds, and, in active funds, across different management styles.
REFERENCES/SOURCES
https://www.investopedia.com/terms/d/diversification.asp
https://www.investopedia.com/articles/basics/05/diversification.asp
https://www.jhinvestments.com/viewpoints/investing-basics/understanding-stock-bond-correlation
