Diversification is an investment strategy designed to reduce exposure to risk by combining a variety of different types of investment whose values may not move in the same direction at the same time.
Many investors discovered the need for diversification the hard way in 2008, when the share prices of many companies that were previously viewed as safe and reliable collapsed. Here we outline why investors should consider diversifying, and how they should go about doing it.
Diversifying in Equities: Umbrellas and Ice Creams
Suppose Joe invests €100,000 in a company that makes ice creams, which he believes is well run and has good growth prospects. He expects to make a 7% per annum return from this company.
Now suppose that in a given year, the summer is unusually wet and cold. Ice cream sales suffer and the share price falls by 20%. Joe’s investment is now worth only €80,000.
Now suppose that, instead of putting all his money in the ice cream company’s shares, Joe had put half of it, €50,000 in an umbrella company, and the other half in the ice cream company. Because of the wet, cold summer, the umbrella company has a bumper year and the share price gains 34%. Joe’s investment in the umbrella company is now worth €67,000. However, Joe had put €50,000 into ice creams, which has now become only €40,000 as a result of the bad weather. Overall, Joe’s investments are now worth €107,000, which means that Joe has obtained his 7% growth. Because Joe diversified his investments he protected himself against adverse trading conditions and still earned a 7% return on his investment.
Is diversifying between shares enough?
In reality, even if Joe splits his portfolio between the umbrella company and the ice cream company, he has not adequately diversified. If stock markets have a bad year, it is likely that both the umbrella company and the ice cream company will see falls in value, regardless of whether there is sunshine or storms. In fact, regardless of however many shares Joe holds, from however many countries and however many industry sectors, he is going to see falls in value if global equity markets fall across the board.
The answer here is to diversify by using other asset classes, which ideally should be capable of performing in periods when equity markets do not. Equities tend to be the main growth asset for medium, medium-high or high risk portfolios. To complement equities, you should look for asset classes with ‘low correlation’ to equity markets.
- Cash does not move with equity markets
- Government bonds in general tend not to move with equity markets, and are thus a good diversifier
- Historically, property has not always correlated with equity markets. However property did fall at the same time as equities in the 2008-2009 downturn
- Alternative Investments are typically designed to move in an un-related way to equities
Please note however, that as 2008-09 showed in relation to property and equities, asset classes that have not correlated with each other in the past can become closely correlated in unusual periods.
Ideally, then, an investor should hold not just several different holdings in one asset class, but should actually hold several different asset classes. High risk investors, targeting high levels of growth, are likely to hold higher proportions in equities than lower risk investors.
Diversification and property
2008 provided a lesson in the dangers of investing only in shares, as share prices plunged dramatically. However recent times also delivered a lesson on the dangers of investing purely in property. This danger is increased if high levels of debt are taken on to buy that property.
Most Irish investors are already exposed to the property market if they own their home, as it can increase or decrease in value. If you own your home in Ireland there is a very strong case for not buying more Irish property as this increases exposure to the Irish property market. From a diversification viewpoint, it is bad practice to buy a new house while keeping your old one and letting it out, as this involves loading up on a single asset class, in a single country.
Those who own a house should consider putting any additional property investment into commercial property and even into property outside Ireland. However unless a fund is used, owning foreign property may involve complicated legal and tax obligations. Better still, for homeowner’s, additional investment in property should be limited. Other asset classes, such as equities or bonds should form a greater part in an investment portfolio.
Diversification: not the cure for all ills
Of course, diversification cannot protect against all possible losses. Taking risk implies the potential for loss. It does make sense to diversify a medium risk or a medium-high risk portfolio as a means of reducing losses in the bad years. But even a well-diversified portfolio is likely to be hit when markets fall.
Take for example two investors, John and James, who are unfortunate enough to invest €100,000 each just before stock markets fall by 50%.
John invests his full €100,000 in equities. He sees the value of his investment drop to €50,000.
James is also willing to take a relatively high level of risk, but he diversifies. He places:
- 50% of his portfolio in equities, which drop 50% in value
- 20% of his portfolio in government bonds, which gain 15% in value
- 15% of his portfolio in alternatives, which gain 5% in value
- 15% of his portfolio in property, which drops 30% in value
The above is a (very approximate) example of what happened to many portfolios in the worst twelve month period between 2008 and 2009. In this example, James, with the diversified portfolio sees ‘only’ a 26% drop in value, relative to John who had lost 50% by relying on one high risk asset class. This is an extreme investment scenario and the numbers do not reflect a typical investment year.
However, this demonstrates an important point: when markets go bad, diversification may only help to a degree. Investors who cannot tolerate sharp short term losses should moderate the degree of risk they take by keeping the proportion of their wealth that they hold in low risk assets such as cash relatively high.
Are there any reasons not to diversify?
A high risk investor may have great confidence in an individual company and may wish to place very substantial amounts of his investment in that one company, regardless of the arguments for diversification. If he is right about the company’s prospects, this approach will maximise his growth potential. However this investor would need to be able to afford total loss in a worst case scenario: for example if the company goes out of business. A diversified investor is unlikely to face the same potential for loss as the stock market as a whole is unlikely to disappear.
At the other extreme, a minimal risk investor may be unwilling to risk any loss in value, and may wish to place his or her money in a bank account or with An Post. The main risk here (aside from the risk of government or bank default) is that inflation may rise, eating away the real value of the cash deposit. This provides an argument for taking some capital risk with a portion of a portfolio, if only as a long-run hedge against inflation.