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.
How many individual investors have carefully built a portfolio across multiple asset classes using direct investments in stocks and bonds, for example, and through breadth alone believe they are diversified?
How many individual investors have carefully built a portfolio across multiple asset classes using direct investments in stocks and bonds, for example, and through breadth alone believe they are diversified? It is unlikely they have selected such underlying investments randomly, and so whatever philosophy and process has led them to their investments might leave them undiversified in this second dimension. But what if they have outsourced this expertise in investment to a third party? For sure, they might be able to diversify in the first of the dimensions, but can they really in the second? Any individual, whether an investment professional or not, is likely by themselves to be able to diversify by the type or style of investing.
What conclusion does this lead us to? Simply, more is more when it comes to diversifying. It is not simply enough to invest across multiple asset classes and sub asset classes if you want active stock and bond selection – diversifying your underlying investment managers is of significant importance. Multiple decision-makers, assuming they are each skilled in their roles, are likely to deliver a better – in risk-adjusted terms – return, than any individual decision-maker, however skilled he or she might be.
James Bateman is head of portfolio management in Fidelity’s Investment Solutions Group
