The basics of diversification

Diversification is nothing new; there has been a gradual journey for many pension schemes from regional equities to global assets. This is increasingly being replicated by retail investors.

Even where exposure is country-centric, it’s usually split across a number of companies. The following provides a simple example as to why all investors should seek diversification to some degree. If an investor only owned one equity, the upside could be almost limitless but the downside risk may be considered too high. One example that illustrates this is Legal & General Group Plc. Its share price increased by over 1000% from mid-March 2009 until end June 2017 but, in the three years previous to this period, the share price had fallen over 70%.

By owning a range of equities, investors can target long-term returns with less downside risk and less potential upside. If investors were reckless gamblers, their decisions might be different, deliberately seeking out concentrated risks in the hope of winning big on the performance of a single share. Almost everyone is risk adverse to some extent and so looks to remove avoidable risks.

The idea with a diversified multi-asset portfolio is similar. An investor owns a wide spread of assets, so it’s unlikely that returns will be stellar, as that would require everything to perform at the same time. However, just like choosing individual equities, it is difficult to choose outperforming asset classes without significantly altering the overall portfolio risk. A high proportion of the benefits of diversification are best achieved by maintaining exposure to a broad range of investments.

Diversification as a source of return

The risk management properties of diversification are well understood. What’s less well known is that diversification can actually increase the rate of return investors achieve over time. This is sometimes known as the ‘diversification bonus’.

Performance volatility of a portfolio can affect the overall rate of returns as large drawdowns can have a serious and detrimental impact on returns. For example, a portfolio that suffers a minus 50% return followed by a plus 50% return (or vice versa) is only worth 75% of its original value. Diversification reduces the size of the worst events, or volatility, and so this detrimental effect can be reduced. So when thinking about the expected rate of return on a diversified portfolio, particularly in comparison to a more concentrated portfolio, it is important to allow for this additional source of long-term return. As large swings in returns are reduced by diversification, this may result in a systematically higher rate of return than the weighted average returns on the underlying investment would suggest. This point is frequently missed when assessing the return potential of strategies.

Earning the diversification bonus

For the diversification bonus to work, it is important that the portfolio rebalances periodically; if not, the rate of return achieved must be the same as the weighted average of the underlying investments. Otherwise, it is simply the same as holding several segregated portfolios of different assets.

Systematically reducing exposure to the best performing assets and reinvesting the proceeds into those that have performed least well, in order to get back to the target portfolio weights, is rebalancing in the same way as the old saying, ‘buy low and sell high’. Even more importantly, this effect compounds over time.

Hindsight is the mental curse of diversification

Just as there will always be an individual equity that outperforms all the others, there will always be an asset class that outperforms within a diversified portfolio. The temptation is to believe, with hindsight, that this outperformance was inevitable and the winning strategy was obvious; that in this instance, putting all the eggs in one basket was a good strategy.

The same can of course be true over the longer term. For example, from 1994 to 2012, US dollar denominated emerging market government bonds gave a return in local currency of over 500%. However, just because an asset class demonstrates strong performance over an extended period, it doesn’t mean that this performance will continue into the future, evidenced by the performance of emerging market debt over the five years since 2012(22.6%)*. This highlights the potential dangers of assuming history repeats itself or that asset class movements are accurately predictable in advance.

Always bet on the house

Some view investing as making a series of bets. In reality, being a diversified investor is a bit more like owning a casino, rather than being a gambler at one of the tables. There will always be individual investors who through a combination of luck and skill leave with a better return on their investment than the casino owners. But there will also be those who do worse, far worse. And much like a casino, accepting lots of small investment bets can provide a source of sustained and systematic income that concentrated gamblers can’t benefit from.

The complexities of diversification go to show that there are no simple investment decisions. However, even where an investor has high conviction views on particular markets, the arguments that favour diversification are persuasive and it is likely to still play a role. In cases where an investor has few strong market views, it can form the cornerstone of a strategy that offers more than the sum of its parts.

*Based on the JPMorgan EMBI+ index, the return in USD over 5 years to end July 2017 is 22.6%. Source: Bloomberg.

Disclaimer: Past performance is not a guide to future performance. The value of any investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested. Legal & General Investment Management Ltd, One Coleman Street, London, EC2R 5AA www.lgim.com Authorised and regulated by the Financial Conduct Authority.