“Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.” (Warren Buffett)
This is all very well, Warren, but we can’t all afford excessive risk.
For this reason, Harry Markowitz coined the phrase that diversification is the only free lunch in investing. The concept is that owning a more comprehensive range of investments will reduce the risk in your portfolio, minimise loss and provide more constant returns.
But while diversification is widely accepted as a sound fundamental investment principle, and we believe it is advisable, there is a cost to everything in life. In other words, Warren Buffet does have a point.
Diversification 101
Diversification is an investment approach used to reduce risk and volatility. It involves investing in various investments within a portfolio, such as different companies, industries, sectors, and asset classes in varying geographical regions.
Ideally, your investments should have a low or negative correlation with each other. A negative correlation means that the values tend to move in opposite directions. For example, historically, equity and bonds have a negative correlation.
Diversification aims to limit exposure to any single investment and thus minimise the potential for financial loss if a particular investment underperforms.
Is there a hitch?
There are some costs associated with diversification, including:
- A diversified portfolio may have lower returns than a concentrated portfolio that uses a few high-performing investments (but how long will they remain high-performing?).
- Assembling a diversified portfolio is complex (and correlation is not constant), and it takes time to monitor and rebalance multiple investments and ensure they are aligned with personal investment goals. (This is where we come in!)
An additional catch – we’re only human
To be appropriately diversified means holding assets that will be disappointing, including some which we actively want to underperform. For instance, your Holiday Fund, or more importantly, your Emergency Fund, may be invested in money market unit trusts that will most likely (based on historical returns) underperform equity in the long run. But the reduced (yet certain) return is welcome, as these are short-term and essential investments.
Our behavioural biases constantly threaten diversification. If equity is having a bull run, you may be tempted to switch part of your Holiday Fund into equity in the hopes of being able to afford two holidays a year. But if the market narrative changes, you may end up having to have no holidays at all!
Foresight is better than hindsight
When reviewing your portfolio’s performance, diversification often feels like a bad idea – it’s natural to wonder why you didn’t hold more of the assets that provided the highest returns. But the cost (or what you could regard as a loss) is worth embracing, as things will be different in the future.
Diversification requires us to own positions that haven’t performed well, and we don’t expect to always perform well. That doesn’t mean we should trustingly hold any asset regardless of its fundamentals. But we must accept that being well-diversified requires always having some dead wood in our portfolios.
Forget free lunches
No successful investment strategy provides a free lunch; everything always comes at a cost. For diversification, this cost is daydreaming about how much better things could have been if you’d stuck to the top performers only.
While Warren Buffet may say that diversification is only for the ignoramus, we believe your portfolios should remain well-diversified and tailored to your individual and ongoing personal goals.
Contact us if you’d like to discuss the reasoning behind your investment’s asset allocation and the extent to which you are diversified.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.
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