Diversification or ‘diworsification’

Diversification or ‘diworsification’

When advisers review clients’ portfolios it is likely that the type of investment as well as an analysis of the underlying holdings will take place. This is done to ascertain the client’s current asset allocation, that is the percentages of holdings in the different types of asset classes such as cash, bonds and equities.

The portfolio is assessed for diversification – how well spread the holdings are in these asset classes. But when portfolios are altered and reviewed, how can you ensure that client portfolios are really as diversified as we think?

What is diversification?

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An easy analogy is ‘not putting all your eggs in one basket’. By investing in different types of investment we spread the risk so that if one particular investment (or one particular area of the marketplace, such as banking) falls suddenly, the entire portfolio is not affected.

The key though is remembering that diversification works effectively where the assets held are not well correlated to each other. For example, if there are two uncorrelated assets in a portfolio and one falls to zero, the other would be largely unaffected by the fall. So the assets may be in different geographical sectors of equity markets or different asset classes entirely.

Having two assets that are perfectly uncorrelated is highly unlikely in today’s global markets, but the aim would be to minimise the movement in the second asset if the first one fell in value. Diversifying helps to reduce the volatility in the portfolio, or the excitement, if you like.

What if I don’t believe in diversification? Some people believe that they can find the next Microsoft, put all their money on one share like that and make millions. That, however, is taking an enormous risk. It’s great if you can be 100 per cent certain that your one investment will sky-rocket, but frankly the probability is that it won’t.

Decisions, decisions...

In order to achieve something like this you always need to make the right investment decisions and at the right time. Historical evidence and plenty of research reveals that this approach has a pretty slim prospect of success.

So which assets are not well correlated (or uncorrelated)? Cash, bonds, equities and commercial property are the traditional discrete groups. However, there is some degree of correlation between each of them and the aim, remember, is to minimise that correlation.

Can we overdo diversification and make portfolios over-complex and higher in charges? Having more funds in similar sectors (often with an overlap of some of the underlying holdings) will result in ‘diworsification’, a term coined by Peter Lynch, ex-fund manager of Fidelity Magellan in his book “One Up Wall Street”. His suggestion was that a business that diversifies too widely risks destroying its original business because management time, energy and resources are diverted away from the original investment.

So buying too many assets with similar correlations will result in an averaging effect, thereby lowering potential returns and the chances of outperforming a benchmark. This is particularly relevant at the lower end of the risk scale. Similarly, seeking to reduce risk by spreading a large portfolio across multiple portfolio managers only reduces the effect of one of those managers making an error.