Money Matters
Diversification
What is diversification and does it really protect you in a financial crisis?
EMILY PERRYMAN
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f we all went to investment school one of
the first lessons we’d be taught would be to
diversify our portfolios. The idea is that if
we spread our money across stocks, assets
and sectors we’ll be able to grow our money and
protect ourselves from risk, whatever the global
economy throws at us.
The investment industry has relied on this
principle for more than 50 years, but a school of
thought is emerging that diversification doesn’t
protect us in times of economic downturn and
can even make us worse off.
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at the behaviour of 30 stocks in the Dow Jones
Industrial Average over a 72 year period. Their
research, ‘Quantifying the behaviour of stock
correlations under market stress’ by T Pres et al,
found the average correlation among the stocks
scaled linearly with market stress and that ‘the
diversification effect which should protect a
portfolio melts away in times of market losses,
just when it would be most urgently needed’.
‘In other words, in a crisis when you need
diversification to stabilise your portfolio, it
disappears as stocks all correlate. Diversification
is something that is there when you don’t need it
and absent when you do,’ explains Marson.
Another paper, ‘International Diversification
works (eventually)’ by C Asness et al in 2010,
claimed that international equity diversification
doesn’t help you in periods up to about five years
but it does help if you can ride out the pain and
wait for valuation and fundamental effects to
reward you beyond five years.
‘In summary, if you can find an investor whose
activity and mind-set is unaffected by market
ine
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STOCK CORRELATION
The benefits of diversifying your portfolio by
sector and region have also been called into
question. In 2012 a group of physicists looked
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UGLY FACTS
The theory behind diversification is that holding
a basket of stocks or a basket of markets/assets
is more stable and robust because when one
goes up another goes down. Paul Marson, chief
investment officer and co-founder of Monogram
Invest, says this makes the key assumption
that correlations between assets are stable and
predictable over the course of an economic
cycle, whereas in reality they’re not.
Traditionally if equities fall bonds rise, but
this isn’t always true. When the markets crashed
in 2008 the historic correlations between
assets changed rapidly and they all went down
together, meaning portfolios that appeared to be
diversified still suffered.
‘Investors place far too much faith in
diversification: it is the financial market
equivalent of the miracle cure, it spreads risk
and enables your portfolio to withstand market
storms, it enables you to sleep well in your bed
at night. In practice, the truth is somewhat less
convincing. As Thomas Huxley said “the great
tragedy of science is the slaying of a beautiful
theory by an ugly fact”,’ says Marson.
Money Matters
Modern Portfolio Theory
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MODERN PORTFOLIO THEORY was introduced by Harry Markowitz in the 1952 Journal
of Finance. Markowitz developed a mathematical model for diversification, which aims
to prove the concept that investors should select portfolios rather than individual
securities. According to the theory, it is possible to construct a portfolio which offers
the maximum possible expected return for a given level of risk. The fundamental tenet
of the theory is investors are willing to accept more risk (volatility) for higher payoffs
and will accept lower returns for a less volatile investment.
There have been lots of criticisms levelled against Modern Portfolio Theory. The
framework uses lots of assumptions about investors and markets, which many people
argue don’t reflect the real world. Some say there isn’t any evidence of a permanent
correlation between risk and return, and that volatility isn’t necessarily a good
measure of risk.
Markowitz won a Nobel Prize for his work in 1990.
RISKY TACTICS
These arguments go against one of the key
facets of Modern Portfolio Theory – namely that
spreading your money across different assets »
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THE PEAK-TO-TROUGH DECLINE IN PORTFOLIO VALUE
0
-10
-20
-30
-39.6%
-49.6%
-40
Source: Monogram Invest
crashes (like 2000 or 2009) and who can see
through the pain of large drawdowns and play
the long game, diversification is just the thing he
needs. Surely someone with that long run/no fear
mentality should just buy a market index in the
cheapest market, after all we know value works
over the long run,’ argues Marson.
He claims many mutual fund managers
underperform because of industry pressure
to diversify, which dilutes their investment
insight and strong conviction stocks. ‘Advisers
and consultants almost force managers to
underperform; the manager picks perhaps a
dozen very strong conviction stocks but the
adviser/consultant looks at the volatility and
forces the manager to add perhaps another 10
to 20, or more, stocks to diversify away that
idiosyncratic insight,’ he explains.
-50
-60
-70
UK (2000/3)
ave 19 ex UK
(2000/3)
-63.4%
-62.4%
UK (2007/9)
ave 19 ex UK
(2007/9)
Maximum Drawdown Experienced when the US Market had NEGATIVE MOMENTUM in the
2000/3 and 2007/9 Bear Markets: Drawdown for the UK Market versus an equally
weighted basket of 19 markets (US, Jpn, Fra, Ger, It, Esp, Swi, Bra, Chn, Ind, Rus, Can, Astl, Kor)
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Money Matters
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Multi-asset funds:
the easy option?
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A SIMPLE WAY of achieving diversification is through multi-asset funds,
which invest in other funds or in a mix of shares, bonds, direct property
and cash across different countries and sectors.
Gavin Counsell, multi-asset fund manager at Aviva Investors, says
multi-asset funds take away the challenge of portfolio governance from
investors. ‘To do well you need the resources and time to look at and
understand markets across the globe. You need to be responsive to the
changing market environment, which can be hard for an individual to do.’
To search for multi-asset funds on Morningstar you need to select
the IMA sector ‘Mixed Investment 0-35% Shares’, ‘Mixed Investment
20-60% Shares’ or ‘Mixed Investment 40-85% Shares’. These categories
dictate how much equity exposure the funds have. There are also rules
about their holdings in other asset classes and currencies, but the
exact exposure will vary from one fund to another so don’t assume
they’re all the same. There are lots of different investment styles within
each sector.
The Mixed Investment 0-35% Shares category caps a fund’s holding
of direct equities at 35% and it also requires a minimum of 45% in fixed
income and cash. In addition, 80% must be invested in established
market currencies with at least 40% in Sterling. JP Morgan Cautious
Managed Class C Inc (GB00B235HG00) has returned 24.7% over the
past three years by investing primarily in fixed income securities,
convertible bonds, equity securities and short-term securities of
issuers located in any country.
Funds in the Mixed Investment 20-60% Shares category must hold
at least 30% in fixed income or cash and 60% must be in established
market currencies. Standard Life Investments Dynamic Distribution
Inc (GB00B7JNXM18), which is up 8.7% over the past year, invests
in Standard Life Investment’s collective investment schemes, giving
it exposure to predominantly sterling-denominated assets such as
equities, bonds, property, cash deposits and money market instruments.
The Mixed Investment 40-85% Shares category has no minimum for
fixed income or cash. It requires a 50% investment in assets priced in
established market currencies, of which 25% must be in sterling. CIS
Sustainable World Trust C Acc (GB00B882H241) invests primarily in
equities with some fixed interest securities and cash. Its top holdings
include BT (BT.A), Walt Disney (DIS:NYSE), St Modwen Properties
(SMP), Starbucks (SBUX:NDQ) and Smith & Nephew (SN.). It has
returned 53% over the past three years compared with the sector
average of 30%.
GETTING STARTED
If you’re convinced diversification works – at
least in the long-term – then how do you go
about building a diversified portfolio, and how
do you ensure it’s diversified in the ‘right’ way?
Husselbee says the starting point should be
equities because they’re the main driver of
investment returns.
‘If you have an investment timeframe of 10 to
20 years and can lock your money away volatility
is not really a problem. If you have a shorter time
horizon (but we usually say you shouldn’t invest
for less than five years) you can take the volatility
out by diversifying into other asset classes like
bonds, which provide income and have a low
correlation to equities, property and to an extent
cash to preserve your capital.
‘As you diversify away you don’t lose the ability
of returns – you just smooth away from the
volatility,’ he explains.
Husselbee suggests investors put their money
in alternative assets alongside traditional
investments. ‘Strategic bond funds give you the
ability to not only invest in a wide range of fixed
income markets, but also in varying durations
which protect you when there is rising inflation,’
he says.
Splitting your investments between equities
and other asset classes is just the first layer
of diversification. You could also consider
spreading your money across different
countries, regions and currencies, between
passive and active investments and between
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Source for performance data: FE Trustnet, 31 July 2015.
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will reduce your portfolio’s volatility and improve
its stability.
The vast majority of financial advisers and fund
managers believe one of the worst mistakes an
investor can make is to not properly diversify
their portfolio. Putting all your money in the
latest hot stock is an incredibly risky tactic which
could result in you losing all your money.
‘Modern Portfolio Theory is the basis for a lot
of portfolios and Nobel Prizes have been won
for it. The industry has run for many years on
the principle of not putting all your eggs in one
basket. If you have a short-term trading strategy
diversification is not a tool you use, but over the
long-term it works – it gives investors a much
smoother journey,’ says John Husselbee, head of
multi-asset at Liontrust Asset Management.
Money Matters
large and small cap stocks.
How to create a diversified
portfolio
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DIVERSIFICATION LAYERS
‘Small companies are riskier but over the longterm they outperform the main markets so you
get compensated,’ explains Anna Sofat, founder of
Addidi Wealth, a financial advice firm for women.
The make-up of your portfolio will depend
on your attitude to risk and your investment
horizon; a 30 year old can usually afford to take
on more risk through equities than a 60 year old
can. Sofat says a 30 year old could opt for Addidi
Wealth’s 100% risk portfolio, which has 10% in
property shares, 20% in emerging markets and
70% in the developed world markets. Someone
at retirement might be more suited to the 40%
risk portfolio, which allocates around 4% to
property shares, 8% to emerging markets, 14%
to developed world markets and 60% to gilts,
trackers and bonds.
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Within these asset classes spread your money between:
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TOO MANY BASKETS
It’s possible to get carried away with
diversification and this has led to the, quite
frankly terrible, word ‘diworsification’. Putting
your eggs in too many baskets can be just as bad
as putting them all in one basket.
‘It’s definitely worth looking at the benefits
of each additional investment exposure,’ says
Gavin Counsell, multi-asset fund manager
at Aviva Investors. ‘After you make your first
investment the biggest risk reducer is your
second idea; the third idea helps but it’s not as big
as the first one. There is a certain level at which
risk reduction doesn’t add value.
‘Each position should be material to your
overall portfolio. It’s better to have big conviction
ideas than thousands of small ones that you’re
just sticking in for the sake of it.’
If you have hundreds of holdings it will
be incredibly difficult to keep track of your
portfolio and you’ll spend a big chunk of your
money on dealing fees and annual management
charges. You could also end up investing in funds
which provide exposure to the same companies,
meaning your portfolio isn’t as diversified as
you think.
‘I’ve seen people invested in 50 funds and
shares for a modest-sized portfolio. The
transaction costs are higher and although any
losses are minimised so are the gains,’ says Sofat.
Spread your money across different asset classes:
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