May 22 2015

Diversification or ‘diworsification’

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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?

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.

The effects of diversification are laid out in Box 1. So, what is the best way to achieve effective diversification in client’s portfolios?

First you should focus on the risks to which your client is exposed, rather than on the individual securities. For liquid funds, minimise duplication of similar funds.

It is worth noting that for some of the more esoteric funds that are less liquid – perhaps where the underlying holdings are illiquid such as some specialist investment trusts and VCTs – instead of buying a 5 per cent holding in one fund, it would be better to buy 1 per cent holding in five funds to ensure you have the liquidity when carrying out future rebalancing transactions. This avoids moving the price too much when trading.

You should also buy each asset to do a particular job. I have had numerous conversations with advisers who say, for example, that they buy gilts for the clients to dampen down the excitement or volatility in their portfolios but then go on to say that they believe gilts are underpriced at the moment and so a quick profit can be made as they expect the gilts to rise in value quickly. If you are expecting an investment to rise quickly in value it is not going to dampen down the excitement in a portfolio.

Make sure you do your research. You have probably heard of the research by Brinson, Hood, et al, but what did that actually conclude about the importance of asset allocation as far as diversification goes? It said that asset allocation controls the variability in returns in a given portfolio.

Decide on your rebalancing policy and stick to it. Consider rebalancing when each asset class moves by more than an agreed percentage. That percentage should be discussed and agreed by your company’s investment committee. Also consider rebalancing at regular intervals in addition to percentage changes. This may be perhaps quarterly or half-yearly.

Controlling costs

Finally, you must keep portfolio costs down as far as possible. That doesn’t mean cheap or rock bottom prices, but appropriately low.

When the financial crisis hit in the past decade, there were many commentators who saw a case against diversification in the fact that many assets fell together. They argued that it didn’t work then.

However, it is very rare for all assets to fall simultaneously and when it does happen, it may be a short-term phenomenon caused by technical factors unrelated to investors’ perceptions of the merits of an asset class. For example, if you need to raise cash and most of your portfolio has plummeted, you might choose to do so from an asset that has held its value relatively well. If enough people do that, the value will fall, although its fundamentals are unchanged so it probably won’t be long before other investors decide that the price is now too low not to buy it.

One of the resulting outcomes of that financial crisis was the development of a plethora of novel alternative asset classes and techniques which may have hindered rather than helped asset allocators by offering additional and often untested choices, which many institutions lacked the proper resources to evaluate, and which had immature advisory infrastructures.

When traditional choices seem not to work, it is much easier to persuade people that something new will.