Stories about superstar investors making a fortune out of a single stock investment continue to do the rounds, but very little consideration is given to the amount of risk that was inherent in that single investment, and how many other investors employed this single stock strategy only to fall flat. Investing all your money into one stock implies that your return is entirely dependent on what happens to that particular stock.
Having exposure to different kinds of investments that are unrelated, or as we say in financial terms, uncorrelated, prevents an investor from putting all their eggs into one basket and therefore significantly reducing the probability of losing everything all at once.
The first component of the traditional diversification process involves asset allocation, which involves splitting the portfolio across asset classes such as stocks, bonds or real estate (for example). When macroeconomic conditions cause one asset class to perform poorly, the underperformance is more than likely offset by superior performance in another asset class. In the longer term, this results in a smoother return profile and improved capital protection.
The second component of spreading portfolio risk is diversifying within asset classes. In the case of equities, this may include selecting between domestic and global stocks, large, mid and small cap stocks, and selecting industries and sectors offering the maximum risk-reward potential. With regard to bonds, diversification would largely occur across different maturity dates as well as on the type of bond – government, corporate, high yield – for example.
As integral as diversification is to the portfolio construction process, it is not without certain pitfalls. Constructing a diversified portfolio requires in-depth knowledge of each individual investment as well as the ability to rebalance the portfolio in response to changing market conditions - a daunting task even for investors who possess quality resources and information. Maintaining a diversified portfolio can also be significantly more expensive than a concentrated one and the addition of more asset classes or instruments simply contributes to a rise in expenses. These extra expenses cut into returns and have the added effect of magnifying losses during periods of portfolio underperformance.
Simply holding a diversified portfolio is not a guarantee for earning above benchmark returns. Superior investment returns come from choosing the right investment at the right time and then also deciding on what portion of investable funds should be allocated. The ever-changing nature of financial markets makes this search process a continuous one that has the potential to be extremely time-consuming and expensive for the individual investor who wants to make correct and informed decisions.
Luckily there are options available when considering how to diversify your portfolio whilst also tackling some of these pitfalls. These include investing offshore to protect against local risks, in a hedge fund to reduce general exposure to market movements or spreading risk over multiple managers through a fund of funds, amongst others.
Investing offshore helps reduce the concentration risk that comes with exposing all your investments to one market and provides access to the global economy. Offshore exposure can be achieved via Rand denominated unit trusts or by direct offshore investments, depending on individual investment requirements and risk appetite.
Diversifying through hedge funds
Investing in a hedge fund reduces overall exposure to market movements, thus retaining the ability to make a return on an asset even if it declines in value. There are many different hedge fund styles to suit the different personalities, goals and risk appetites of investors.
Diversifying through a fund of funds
Investing in a fund of funds enables you to spread risk over multiple managers through a single product, meaning that diversification is provided without the need for significant investment capital. The individual investor would purchase a unit of the fund, which in turn would be invested in multiple asset classes and multiple underlying managers. This diversification also results in lower price volatility as the unit price of a fund of funds is unlikely to fluctuate as much as the underlying funds that it consists of.
Furthermore, the individual investor does not have to decide on the mix of investments as this task is assigned to a dedicated fund manager who has the skill and expertise to make asset allocation decisions, select underlying managers and to review and rebalance the portfolio on an ongoing basis.
In a fund of funds, because the risk is spread over a number of different fund managers, the negative impact of underperformance from any single manager is offset by the performance of the other underlying fund managers in the portfolio. The exposure to multiple managers also eliminates the risk of you choosing an inferior fund or manager.
While diversification itself will not necessarily ensure gains or provide a guarantee against losses, it does improve the probability of attaining superior performance given a certain level of risk.
Ultimately, it is always prudent for an investor to have some kind of diversification in their portfolio. When evaluating a portfolio allocation, you should consider whether it provides substantial diversified, uncorrelated sources of return. This will allow for the spreading of risk, improved risk-adjusted returns and the smoothing out of portfolio returns over time. Diversifying a portfolio is unlikely to bring quick riches but it will certainly build wealth steadily over time.
Pearlene Govender is a Junior Portfolio Manager at Novare Investments.