By Martyn Wild.
Not paying for your supper
I don't know about you, but I'm more than a bit bored of reading that "diversification is the only free lunch in investing". This is a misleading statement at best. Suppose for now we accept that diversification is free, not only does a lunch being free not imply you should eat it, but I can think of a lot of lunches I've paid for that were worth every penny! Paying for stuff isn't the problem. It's paying more than its worth (or not realising what you are actually paying) that causes issues.
Its is generally posited that as investors, we diversify because adding assets that aren't perfectly, positively correlated with each other reduces the amount of risk we pay per unit of return we receive. In short, we are seemingly getting a bargain by paying less for the returns we get (albeit lower returns). The math backs this up for sure but to us its not the real point of combining assets in a portfolio structure. Knowing why you should diversify helps you decide whether you should diversify.
Diversification über alles, apparently...
As an industry, we seem to think diversification gives us a higher likelihood of achieving our investment goals when in actual fact, we diversify because it reduces the likelihood of not achieving them. The two are not the same. In fact, if you look at an asset allocation you set years earlier at the end of the investment horizon, it will almost certainly will be a bit of a let down if your goal was accuracy. Why? Well, it is highly unlikely that your forecasts were perfect when you originally built the portfolio. Everyone is an expert in hindsight but a total underachiever when it comes to consistently forecasting the future with precision. As such, your portfolio is likely to be inferior to the myriad of alternative structures you could have chosen.
We diversify because we don't know whats going to happen and modern portfolio construction enables us to minimise the bad times by paying for them with the good ones; it does not increase the accuracy of our predictions. Put another way, we can't use diversification to dramatically improve our aim, but we can use it to materially reduce our misses.
An example might help? If we take a risk-free asset like cash and conveniently, we required a return equal to cash then we'd put 100% of our assets into cash. Yep, that's right, we wouldn't diversify at all. Diversification doesn't help us here because investing in cash gives us 100% surety of achieving the investment goal. Certainty is the goal.
The real value of diversification
The real reason to diversify is to reduce the effect of the bad times when they come. While we'd suggest there are almost always opportunities to benefit from diversification and the downside protection it can bring, remember that the higher return you target (past a moderate return portfolio), the less scope there is for risk reduction via diversification - you are substituting less uncertainty for a higher return. As such, protection in any form costs in some way. Diversification, like buying put options to protect against losses, isn't free. The difference is that the 'costs' are largely implicit.
One more thing to think about...
In a low interest rate environment like we are in now, the impact of diversifying equities with bonds is far less meaningful than it was in the past few decades when yields were higher: the return penalty is often too high. We think now is a good time to reassess the role of classic diversification (mixing assets that are less than perfectly, positively correlated to achieve a reduction in portfolio risk) as the primary tool used to achieve the wealth objectives of clients.
Use all the arrows in your quiver.
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Disclaimer: The information provided here is for interest purposes only and does not constitute investment advice or a recommendation of any kind.