Opinion – Diversification doesn’t always pay

20-Dec-2017

By Danica Hampton

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One of the most commonly touted rules of investing is to create a diversified investment portfolio. Investment guru Warren Buffett is critical of this rule and has been quoted as saying “wide diversification is only required when investors do not understand what they are doing”.

Looking at performance numbers justifies Buffett’s view: diversified investment portfolios do not typically produce the highest returns for investors. Usually it is a portfolio that is concentrated in either a sector or asset class that materially outperforms and will head the investment returns leader board.

If diversification doesn’t pay off in terms of the highest returns, why is it such a big focus for investors? Diversifying your investments is typically heralded as a way to spread out your risk and to reduce the volatility of your investment returns.

At first blush, it makes sense. If you invest a little of your portfolio in a lot of different investments, then if one investment turns pear-shaped, it won’t have a large impact on your total investment return. In everyday language, it is akin to not putting all your eggs in one basket.

There are many ways to diversify your portfolio. One way is to own stock in more than one company. But, you can also invest in different industries – owning NAB shares and Telstra is more diversified than owning NAB and Westpac.

You can also look at the size of the company and the geographic location. The investment style can also play a role in diversification – a growth-style manager will invest differently to a value-style manager.

A growth-style manager is more likely to perform strongly during different market conditions than a value-style manager.

There are many benefits to a diversified portfolio. Not only can you spread your risk and reduce your portfolio volatility, but you can gain exposure to different markets.

For example, if Asian equities grow while the domestic market stagnates, a geographically diverse portfolio would reap some of the reward. Likewise, when one company, industry or country performs badly, the other (hopefully uncorrelated) investments in the portfolio will help offset the losses and reduce the overall volatility of your investment return.

But while not commonly talked about, there are also downsides to diversification. The more extensively diverse your portfolio, the more likely you are to simply replicate market returns, most likely at a greater cost than simply investing passively in an index.

A widely diversified portfolio with a lot of different holdings can be more difficult to manage. When rebalancing is required, it is likely there will be more transaction costs as more adjustments will need to be made to a larger number of investments.

Diversification can also create risk if it leads investors to asset classes or markets they know little about. For example, private debt is typically uncorrelated to equity risk so has strong diversification benefits, but it is often more complex and illiquid, so careful consideration is required prior to investment.

Using several managed funds for diversification purposes is operationally simpler, but it comes with a risk of investing in funds with overlapping holdings. Consider this example: you invest in three managed equity funds with different styles – core, value and growth.

At any point in time, all three of your managers might be invested in the same stock – like Alibaba or Amazon – so you may not be as diversified as you think you are.

What’s more, the investment activities of your different managers may actually offset each other. Your value manager might buy stock A, when your growth manager is selling stock A. Your equity exposure might remain unchanged, but you have incurred two sets of transaction costs.

Arguably, the greatest downfall with a diversified portfolio is that it tends to underperform relative to a more concentrated portfolio. Investment portfolios that obtain the highest returns for investors are not typically widely diversified portfolios, but portfolios concentrated in a few industries, market sectors or asset classes that materially outperform.

So what approach should an investor take?

First, you need to take the time to figure out an appropriate asset allocation that meets your own risk and return requirements and provides some diversification across asset classes. However, within a given asset class, instead of focusing entirely on diversification, spending time selecting high-quality investments that you truly understand may provide you with a better outcome.

We are living in unique times; interest rates and bond coupons are historically low, credit spreads are tight, property and equity markets are extremely high.

Against this backdrop, a traditional approach to investing won’t generate the returns we’ve seen over the past decade. A non-traditional approach – even if it creates a portfolio that appears a little more concentrated – may provide investors with a better risk-return profile against the backdrop of current market conditions.

Danica Hampton is head of investment specialists at Citi.

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