Magic number crunch

James Bateman

I have written before about diversification (and, indeed, ‘diworsification’), but this week I thought I would touch on a related subject – diversity of underlying investments in a client’s portfolio.

I was asked earlier this week how to measure the diversity of a client’s investments and was struck that this was not as simple to measure as we might at first think. There is, as with almost anything in finance, a near-endless supply of academic literature on the subject, much clearly written with little practical understanding of investing but with a great deal of number crunching. So I am not about to embark on some mathematical explanation of the principles behind measuring diversification, but instead focus on what I see as the two – separate – dimensions of its measurement.

One dimension is never overlooked: the number of asset classes invested in, and, within this, the number of stocks/bonds/instruments held. It is not surprising to anyone, I hope, that holding one equity fund and one bond funds is, all other things being equal, more diverse than holding just one of the two. Similarly, holding two stocks is more diverse than holding one, and holding 30 (often considered the “magic number” in terms of individual portfolio diversification) is even better on the diversification front. And, while there may well be laws of diminishing returns coming into force, as we add more asset classes and more underlying investments, diversification does increase.

Article continues after advert

I do not know whether there is a magic figure for the number of asset classes, in the way there is for stocks (in theory) but in my experience somewhere between five and six major asset classes deliver a very good level of diversification while remaining manageable in terms of breadth of investment. Equally, while additional asset classes might diversify, if they are not readily accessible and liquid – think timber or wine – then we might argue that their costs outweigh their benefits.

But more important than all of this, I believe, is the second dimension to diversity. For, as with so many things in life, all investments are not created equal. I am excluding passive investing from this dimension of diversification, so those with a penchant for index tracking need not read on. Consider, for example, a portfolio of 100 stocks and 100 bonds. How diverse is this? I would contend that – mathematics aside – even if we know what those 100 stocks and 100 bonds are, we cannot answer this question. The reason? We need to know who – or, more precisely, how many people – made the decisions to select them. One individual, however talented, is likely to have some inherent correlation in their ideas; at the other end of the spectrum, 200 people, each picking one stock or one bond, are likely to produce a far more diversified portfolio. For sure, the second of these is an extreme, but the first is not necessarily. This is important.