Diversification. We often hear investment gurus talk about diversification. How necessary it is, how it is achieved and how you are benefiting from it. They talk about this as if you understand 100% what they are saying. For those who still feel as though your adviser is talking Urdu when saying the word diversification, let’s break it down for you.
First things first. Diversification in our view is the reduction of risk, not the enhancing of returns. By diversifying we reduce the probability of an undesirable outcome. We do not try and shoot the lights out with a diversified portfolio’s performance, we are merely limiting the potential downside losses without giving up too much potential upside.
“Don’t put all your eggs in one basket.” Ever heard that one? Of course you have. It speaks to the horrible idea of losing all of your eggs at once in the event of a catastrophic failure of your one egg-basket. So what do you do? You get some more baskets, and spread your eggs across the baskets to reduce the magnitude of loss in the event of a fallen basket.
The exact same principles apply when we talk about investing. Investing in only one instrument or asset class will increase the probability of an undesirable outcome.
In hindsight it is always easy to identify the best performing share or asset class over a specified time period. This is unfortunately not the case when we have to make a forward looking projection on the potential outcome of an investment. One way to reduce the probability of an undesirable outcome is to diversify your investments between asset classes.
Warning. Here’s where it might get technical.
Let’s look at the difference between an Equity fund and a Balanced fund. The Equity fund invests only 100% in one asset class, namely equities. The Balanced Fund invests in a mix of asset classes throughout time as the fund managers see value in different asset classes. In this example the Equity Fund provides an example of an undiversified portfolio across asset classes, whereas the Balanced Fund demonstrates a portfolio which is diversified across asset classes.
In the graph below we show 12 month performance figures over the time period 1 January 2003 to 31 December 2014. We show the minimum, maximum as well as average 12 month performance figures for the two different funds, together with the probability of loss on the x-axis.
If you look at the 12 month performance of the Balanced Fund (diversified portfolio), we see that on average the return would have been around 18% with a probability of negative returns around 7%. Compared to the Equity Fund (Not diversified) we see that potential minimums are significantly lower, as well as a greater probability of negative returns.
What we can conclude from this data is that by diversifying your investment portfolio you:
- Reduce your probability of an undesirable outcome.
- Protect yourself from large downside losses
- Don’t give up potential upside relative to the risk you are taking.
Has any of this left you more confused than when we started? Feel free to get in touch and talk to us about diversification in your portfolio today.
