Understanding the importance of diversification

Most people are familiar with the phrase “Don't put all your eggs in one basket”. And this saying also holds true when it comes to investing. Barclays’ Senior Quantitative Analyst Will Morris, explains why diversification is important, and gives tips on how you can actually go about achieving it.

 The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

Toby: Before we begin there are a few points that I’d like you to note. Firstly, that past performance is not necessarily a guarantee of future performance. Secondly, that investments can fall as well as rise in value and you may lose some or all of your money. And thirdly, this is not an investment recommendation. If you need investment recommendations, you should consult a professional advisor and discuss your personal context. So Will, one thing that a lot of investors would have read a huge amount about, is diversification. Now I wonder if you can just tell us what diversification actually is.

Will: Sure, well you’re right. Diversification is a bit of an obsession in this industry but that’s for good reason. Investing always carries some degree of risk. When you’re concentrated in just one or two holdings, that really becomes more like a gamble than an investment. Yes, there’s a big upside sure, but there’s also a tremendous downside. So, unless you can predict the future or you’re feeling lucky, or unless you just want to be on a rollercoaster ride, the best thing is to spread your investments across a range of asset types in different countries and different regions.

Toby: So, basically don’t put all of your eggs in one basket.

Will: Exactly, and that’s obviously because you could lose it all in one go. But there’s another level to it as well. So if you think about what’s actually driving the returns on your investments, you could be invested in lots of different companies that are all exposed to the same thing, like the price of oil. Now that’s like investing all of your eggs in different baskets that are actually all tied together, so that's not much better. An alternative metaphor is to think about having a balanced diet. Investing in lots of similar companies is really like eating lots of different types of meat: ultimately, it’s all just protein. What you’re aiming for is a balanced diet across different nutrients.

Toby: But, surely when it comes to investment management we’re looking to pick the best things. So, doesn’t diversification just mean that you’re going to end up with a mediocre performance?

Will: Well it’s a guarantee that you’ll be at neither extreme. A diversified portfolio will never outperform the top-performing asset, but neither will underperform the worst-performing asset. Now if you don’t know which is going to be the top performer in advance, that’s the only sensible way to go about it. Now, this doesn’t mean that diversification can protect you against losses. If all assets fall in value at the same time, there’s no way to avoid that. But there is another more abstract benefit to diversification and that is the idea that some assets can move in different ways in the short term. So for example shares may go up one month and down the next, for bonds it could be the other way around. If you invest in both of them, you get a nice smooth blend.

Toby: So, a smooth blend sounds nice but surely if one thing is going up and another thing is going down my returns are going to be pretty much flat, aren’t they?

Will: Well they might be almost flat in the short term but it’s important to remember the bigger picture. So, it’s perfectly possible that both shares and bonds have an upwards trajectory in the long term but that doesn’t mean they can’t have different short-term behaviours as well. So, it’s important not to confuse the two.

Toby: So I’m sold on the benefits of diversification, how do I actually go about achieving it?

Will: Well there’s two ways to look at it. The first is, in terms of broad asset classes, you want to make sure that your overall portfolio has a level of risk which is right for you, and also that it’s not concentrated in one particular asset class. The second way to think about it is within those asset classes, make sure you’re not concentrated or have an unnecessary bet in a particular industry or in a particular country or even in a single company. Now as for actually going about this, it can be easiest to use funds where they’ve done the diversification job for you. But of course you have to pay a fee for that. It’s up to you whether you think that fee is good value for money.

Toby: Okay so, talking about value for money then, how much should we diversify as investors? Is it possible for example to diversify not enough or too much even?

Will: So that’s a tricky one to answer. It really depends on the context of the industry you’re looking at or the country, and it depends on your ability and willingness to take risks. It’s not as if we can say that 20 shares is not enough but 21 is just right. What we can say for sure is that a portfolio of just a few holdings has a lot of room for improvement. Now, as for how much diversification is too much, if you’re a fund manager whose job it is to outperform those benchmarks, then there’s clearly room for too much diversification. But otherwise, it’s quite hard to be over diversified unless you’re looking at the level of broad asset classes where if you aim for maximum diversification, you’re inevitably going to peg yourself at a level of risk that might not be right for you.

Toby: So, investors shouldn’t be putting all of their eggs in one basket but there are a few elements that they need to understand as they go about building a diversified portfolio.

Will: Absolutely. If they’re unsure at all, speak to an advisor.

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