Diversification: how to enjoy your free lunch
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DIVERSIFICATION has been called “the only free lunch in investing”. So how does it work and how does it benefit you?
“Spread your bets.” “Don’t put all your eggs in one basket.” The benefits of diversification have long been known to mankind, as these well-used phrases confirm. Yet how often do we hear of people losing their entire life’s savings through a single failed investment?
While on the face of it the concept is simple enough, to structure a well-diversified portfolio requires some effort and thought. There are different ways of diversifying your investments, depending on your investment goals and time horizon.
Higher-risk investments, such as equities and listed property, are necessary in a long-term portfolio for achieving above-inflation growth. However, the risks associated with these asset classes need to be carefully managed, and diversification is key to managing risk. Lack of diversification leads to concentration risk, the investment industry term for having all your eggs in one basket.
In an article for Forbes magazine, “How diversification works, and why you need it”, Rob Berger and Benjamin Curry explain that diversification is not designed to maximise returns in the short term. “At any given time, investors who concentrate capital in a limited number of investments may outperform a diversified investor. Over time, however, a diversified portfolio generally outperforms the more focused one,” they say.
How to diversify your investments
The secret to diversification is noncorrelation. If two assets are correlated, they move up and down in tandem; if they are non-correlated, the one will move up while the other moves down – in other words, the same market conditions will affect the assets in different ways.
You can find a degree of noncorrelation within and across asset classes, as well as across unit trust funds with different investment styles.
Another form of diversification, which is beneficial to South African investors for a number of reasons, is across geographies.
1. Diversification within an asset class. This applies particularly to equities. For example, defensive stocks (companies that provide essential products or services, such as food), tend to weather market shocks better than companies trading in luxury goods. Some equity sectors are highly cyclical: mining shares can reap handsome returns during a commodity boom, as we are experiencing currently, but will underperform at the bottom of the commodity cycle.
2. Diversification across asset classes. The multi-asset portfolio, such as in the example cited in the box below (“The diversification premium”), provides this sort of diversification. Equities and bonds, in particular, tend to be uncorrelated in their performance.
3. Diversification across investment styles. Funds in the same category may have different investment styles based on differing investment philosophies. Value managers, for example, choose shares that offer good value for their price. Other styles are growth (fast-growing young companies), momentum (shares that are following the upward movement of the market), and quality (“blue-chip” companies).
4. Diversification across geographies. Having a certain portion of your portfolio offshore means you are investing in a range of companies and sectors you wouldn’t have access to otherwise. You also hedge against currency volatility.
Don’t fall into the trap of thinking that just because you have many assets in your portfolio, it’s diversified.
“It’s important to consider the correlation between the investments in your portfolio,” Berger and Curry say. “Even if you own many different investments, if they all trend up or down together, your portfolio isn’t appropriately diversified. For instance, high-yield bonds often have a positive correlation with stocks. Therefore, a portfolio made up entirely of highyield bonds and stocks is not well diversified.”
Lebo Thubisi, head of manager research at Alexander Forbes, is responsible for researching funds for the company’s multi-manager division. (Multi-manager funds, also known as funds of funds, invest in other funds, rather than directly in investment assets.)
Thubisi says that achieving optimal returns for investors requires careful risk management, through purposeful diversification. “This means spreading risk effectively so that no single asset class, investment style or asset manager will ever dominate the fortunes of our portfolios. We look to find out which styles of fund management ‘work’ – those that are more likely to outperform over time, are more predictable, and complement each other. Examples of such investment styles are value, growth, momentum and size.
“A good example of concentration risk was the period between 2012 and 2015. Value as an investment style in South Africa was concentrated in resources stocks, which underperformed considerably over that period. Through purposeful diversification, we were invested across other investment styles, such as momentum, which fared better.”
It is possible to be over-diversified – in other words, when non-correlation begins to dampen returns.
Thubisi says that to prevent underor over-diversification, you need to monitor your portfolio constantly, rebalancing where necessary.
“We monitor a portfolio by continually checking to see if it’s performing in line with our expectation from a risk and return perspective, given current market conditions. If the risk is out of line, we have systems that monitor it. Therefore, we take corrective action by either reducing exposure to an asset class, strategy or asset manager if we believe that the risks are too high (above the limit we set), or add to a strategy if we believe that the payoff profile is in our favour.
“If an investment style performs well and becomes expensive based on a valuation measure, we reduce exposure. When it becomes cheaper, we can add it. Our asset allocation team works within a dynamic asset allocation framework, which constantly monitors markets and the valuation of asset classes,” Thubisi says.