Convention says diversification is a basic aspect of risk aversion, but the truth may not be that simple.
For: Andy Gadd is head of research at Lighthouse Group
Everyone knows and surely accepts that at its most basic level diversification reduces risk. If you own one stock then that will be risky, while owning two different stocks is generally less risky.
That is intuitively correct and makes even more sense if the two stocks are what is known as ‘negatively correlated’.
By this I mean that the risk of owning one stock can be significantly reduced by adding another stock, especially if that additional stock behaves differently to the original stock in various situations.
Correlation basically describes the connection or lack of connection between different investment options.
A perfect negative correlation would mean that if the price of one stock goes up then the price of another stock is likely to go down.
So rather than owning just one stock that makes, let’s say ice cream, you might own two stocks, one an ice cream maker and one an umbrella maker. The result is that when the sun shines the ice cream business makes money, while when it rains the umbrella manufacturer makes money and vice versa.
In investment terms this is known as ‘specific’ or ‘unsystematic’ risk – and in the context of an investment portfolio, unsystematic risk can definitely be reduced through diversification.
The companion of unsystematic risk is ‘systematic risk’, which is also known as ‘market risk’ or by some as ‘undiversifiable risk’.
The argument is that this type of risk cannot be eliminated by diversifying within an asset class, but rather only if you are able to find an asset class that is uncorrelated to other asset classes.
When considering investment options, in my experience asset allocation and diversification are often, wrongly, used interchangeably.
The fact is that even if you are 100 per cent invested in cash, that is still a form of asset allocation. It is not, however, diversification.
When considering diversification and asset allocation one might aim to construct a portfolio that is not only diverse in terms of the underlying assets held within asset classes but ideally holds different asset classes, some of which are potentially uncorrelated so that in various circumstances the positive performance of certain asset classes balance out the negative performance of others, with the aim of smoothing out overall portfolio returns within a particular risk budget.
Ultimately, a correlation matrix is based on past performance – and as we now all fully accept, especially I think since 2008, past performance is no guarantee of the future, especially as we work through what I would describe as the greatest economic ‘experiment’ in history of quantitative easing and tightening.