The Simple Science Behind Diversification

In my ‘10 Shocking Common Mistakes Most New Investors Make‘ article, I tell readers that insufficient diversification is one of the mistakes made by many new (and old) investors. In ‘Do You Need A Financial Advisor?‘ I cite a poor understanding of diversification as the sole reason why several pensioners lost their entire life savings after some UK banks almost collapsed.

So, this article aims to explain what diversification is, why it is fantastic for a small or large investment portfolio, and also what you need to be doing to match current best practice.

What is Diversification?

Diversification is spreading your money across investments that are poorly correlated with each other. If investment A is poorly correlated with investment B, then this means that the day-to-day ups and downs of the two are not related to one another, and are fairly independent. The more investments you spread your money across, the greater the effect of diversification.

What Does Diversification Across a Number of Stocks Achieve?

The aim of any investor is to achieve a consistent annual gain (in excess of the market return if they’re lucky). In reality though, shares do not appreciate by a fixed 1% every month. Instead, stock prices fluctuate wildly around their long term average gains. To further illustrate this, consider the fact that on any given day there is a 46% chance that a single S&P 500 stock will decline in value.

As a result, there are problems with investing all your money in a single stock: Company A.

Problem 1: Stress. You have to live with the constant fluctuation of your life savings. (Psychological effect)

Problem 2: Timing risk. With large fluctuations, you could easily have bought the stock when overvalued, and when you need to sell your shares, the stock could be undervalued.

Problem 3: Risk drag. The phenomenon of ‘risk drag’ means that a stock which provides returns that alternate between -10% and +50% each year (a 20% gain on average,) will return less over the long run compared to a share that returns 20% every year. This seems counter intuitive, but Stephen Warrilow and others understand that it’s a very real and observable mathematical rule, and means that a smoother annual return will result in a higher overall return.

Diversification does not completely solve the 3 problems above, but it reduces them considerably. A diversified portfolio is a smoother portfolio, where the individual ups and downs of each stock are just tiny blips in your overall portfolio movement.

What Will Cause Movements in Fairly-Diversified Stock Portfolio

You may be wondering, what causes movements in a portfolio, if the individual blips of companies securities have been smoothed out? The answer is economic conditions, new regulation, statements by the committees of national banks, and other large and pervasive factors.

This graph shows the movement of the FTSE100, which is a combination of the largest 100 companies listed on the London Stock Exchange. You can see that even with diversification across 100 companies – returns can still be very volatile. But they’re a big improvement on holding just a few stocks!

To attain this good diversification across 100s of stocks, you have 3 options. Option 1, is to make individual trades through your stockbroker and purchase certificates for 100 companies. However, unless you have a £1m+ portfolio, this is going to cost you a small fortune in trading fees, which could knock an instant 1-10% off the value of your investments, and the same again when you eventually sell! The second option is to invest in a mutual fund or Unit trust. In these cases, you buy a few units of a fund, which contains pooled cash from thousands of investors, and is managed by a professional money manager. However, these funds typically charge high management charges, and as a result, net of fees, these funds often underperform the market. The third option is to invest in index funds. Index funds are similar to mutual funds, except they trade like stocks on the exchange, and thus can be bought for just the price of a single trade. These funds are managed by people who, rather than trying to ‘beat’ the market by researching and being selective, invest in the whole market and therefore don’t need costly research, and can keep their management fees low. This is the best way to gain cheap access to such diversification. Some index funds such as ones that track the MSCI Emerging Markets index, will invest in over 2000 companies! All for the price of one trade. Index funds are a very useful tool for investors that didn’t exist 20 years ago.

Going The Whole Hog: Multi Asset Class Diversification.

As you can see from the graph above, simply investing many different stocks will still expose you to the high risks of the stock market. To be truely diversified, one must also spread their money across as many asset classes as possible with positive expected returns. This includes Bank Accounts, Savings Bonds, Corporate Bonds, Real Estate, Equities, and for experienced investors only; hedge funds, commodities and real assets such as fine wine, art and collectibles.

Learning From The Best: How Does Yale Invest its Endowment Fund?

Yale’s endowment fund can teach us a lot about great, multi-asset-class investing. The Yale endowment fund, over the past 20 years has returned on average in excess of 12% per annum. This is a fantastic return, almost unheard of in this industry. This was achieved, not through throwing all their cash into stocks, but by spreading their fund over real estate, bonds, developed equities, foreign equities and hedge funds. Now, the average investor does not have easy access to Hedge Funds, Venture Capital and similar investments like the big boys, however we can still replicate quite a lot of this portfolio without much effort, using Index funds as mentioned above.

Diversification can be seen as a free lunch. For very little cost, and less time spent, in return you receive smoother returns and hopefully lower fees as well!

Simon OatesThe Simple Science Behind Diversification