The Importance of Diversification

By January 10, 2017News

There is a saying related to market investing that the only “free lunch” is diversification. While the concept of diversification intuitively makes sense to most people, there is actually quite a bit of science behind it. In fact Harry Markowitz, the man who came up with most of the maths and theory behind diversification (called “Modern Portfolio Theory”) won the Nobel prize in economics for his work. In this note we attempt to explain diversification and what it means for your portfolio.

Diversification explained

To understand the benefit of diversification it’s important to firstly grasp the true aim of investing. Rather than simply trying to achieve highest possible return, the real aim of the investor is to try and maximise their return while taking the lowest amount of risk. Aiming for one while ignoring the other is not only sub-optimal, it can also be dangerous. Just ask investors who ploughed heavily into technology stocks from 1995-2001. After a number of years of outstanding returns many tech focused investors saw most of their capital evaporate in the subsequent “tech wreck”!

The “free lunch” associated with diversification relates to the fact that it reduces your risk while not necessarily negatively impacting your return. A simple example is to compare a portfolio made up purely of Australian shares, vs a portfolio made up of 50% Australian shares and 50% international shares. Over the long term the returns on Australian shares and international shares are very similar (approx 10% per annum). However from year to year the returns for each market will vary, sometimes significantly. What this means is that over the long haul both portfolios have the same overall expected return. But the journey will be much smoother for the mixed Australian and International portfolio, because the return will be an average of the two markets. Even if the Australian market loses money one year, so long as the return from international markets is positive by the same amount or larger, then the investor will lose nothing.

Some people may ask “so what if my portfolio is slightly more volatile?” or say ”I am a long term investor and don’t mind short term volatility”. Aside from the “sequencing risk” related to higher drawdowns, which I will save for another note, the advantage to taking less risk is that you can turn it into a higher return. This is done by increasing the “exposure” of the lower risk portfolio. Using our example, let’s assume the investor then borrowed some additional money to invest into the mixed Australian and international share portfolio. All of a sudden their expected monetary return on the total portfolio is higher given their greater investment, but their risk (up to a certain debt level) would still be lower or the same as investing in the other Australian only equities portfolio and not borrowing. Essentially you have flipped an equivalent return for lower risk into a higher return for equivalent risk.

Diversification in Practice

In reality most investors, particularly older ones, do not want to take on 100% equity (share) risk, nor do they want to take on debt. And rightly so. While equities have a higher long term expected return than other asset classes, they also come with higher risk. Risk that retirees do not wish to take with their nest egg capital. Furthermore while the returns on Australian and International shares often differ they are still reasonably correlated, particularly during times of crisis. For example during the GFC the value of the Australian share market (ASX200 Index) fell approximately 50% between Nov 07 and Nov 08, however international diversification would not have helped as the Global MSCI Index fell -55% over the same period!

Therefore instead of investing purely in shares, in practice equity investments are combined with other less volatile asset classes to reduce overall risk. Also not only are those other asset classes which are selected less volatile, they are also deliberately non-correlated (or inversely correlated) to shares. This means they provide an outsized risk management benefit when share markets fall by helping offset the losses. Government bonds in particular are good at providing a cushion to equity market sell-off’s, as bonds tend to increase in value when equities sell-off.

At Libero Capital we take a quantitative approach to constructing a diversified portfolio. What that means is that we specifically try to calculate the optimal combination of assets using maths and models which will provide the best risk/return ratio for a client given their specific risk tolerance. The reason we do this is to not only add rigour, but also to ensure the investor is taking the right amount of risk for their circumstances. Unfortunately in this industry one investment firm’s “Balanced” portfolio may be another investment firm’s “Growth” portfolio. In league tables of “Balanced” super funds you will often see one group’s fund consistently at the top in a bull (upward) market, but see them consistently at the bottom in a bear (downward) market. Usually this has nothing to do with their skill, but is more an indication of how much risk they are taking, usually via their fund’s allocation to equities. This is why we feel it is very important to tie everything back to the actual numbers (risk and volatility can be measured) which are sourced from analysing our client’s specific risk profile.

The chart below gives an indication of the asset allocations of Libero client portfolios based on risk tolerance. As you can see, the diversified portfolios have a much better ratio of risk (volatility) vs return. Libero quantitatively measures risk via the “standard deviation” of returns:

Implications of Diversification and Asset Selection

Given that different asset classes (bonds, equities, cash, alternatives etc) perform differently during certain market conditions, it is important to understand that each asset class will go through periods of underperformance and outperformance. This means the return of your overall portfolio will not mimic the highest returning asset class, but will instead be an average of all the asset classes held. For example, the Australian share market finished 2016 strongly, with +7% added to the value of the ASX200 Index over the year. Bonds however recorded their lowest performance in a number of years, with the Barclays Global Bond Index returning only +2.6%. Therefore the performance of a diversified portfolio will be somewhere between the two depending on the investors specific asset allocation, which is determined by their risk tolerance.

Often we are asked why we don’t simply “trade between the different asset classes” and pick the highest returning one at any given time. The answer is that we do go “overweight” and “underweight” certain asset classes based on our investment view, however the future is always uncertain. Particularly in the current political and economic environment where the direction of markets can hinge on the binary outcome of an election result. And even if an election result is correctly predicted, the subsequent actions by central banks also need to be predicted (will they stimulate or not?). No one has a crystal ball. Instead it is far more prudent to look at long term trends and long term valuations and to stay diversified in order to weather all surprises and remain within the appropriate level of risk.

If you have any queries, or would like to discuss the markets or your portfolio in general, please don’t hesitate to call my direct line, 02 9119 3698.

Glen Holder, BCom, DipFP, CA, MAppFin
Director – Investment Management

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Libero has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Libero and therefore is not guaranteed to be complete or accurate, and Libero accepts no liability for errors or omissions. Libero and NWAG do not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.