Want to win? Always bet on the house

Diversification Benefit

Diversification is nothing new and many have embraced it as a way of reducing risk. But how do you avoid the bitter aftertaste that comes with missing out on the chance of higher returns?

Investors generally dislike risk, so it’s no surprise that so many have embraced diversification. It spreads out investment exposures and can reduce the chance of really bad outcomes. As such, it’s often called one of the few ‘free lunches’ in investments; an opportunity to reduce risk without impacting the expected return. But as investors have found out over the last few years, it can feel quite painful to miss out on the returns that, with the benefit of hindsight, a more concentrated portfolio would have given.

The basics of diversification

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

This is the idea with a diversified multi-asset portfolio. 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. 

The "Diversification bonus" - 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. This is best explained through a simple example, as outlined below:

Total returns for equities (FTSE 100) and bonds (sterling corporate bonds) from 1998-2013

The return on a portfolio of 60% equities and 40% bonds from 1998 to 2013 was significantly higher than the weighted sum of the total return on the two asset classes. This is sometimes known as the ‘diversification bonus’. Performance volatility can affect the overall rate of return as large drawdowns can have a serious and detrimental impact on returns.

For example, a portfolio that suffers a -50% return followed by a 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.

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 - a point that isfrequently 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, as shown below, which demonstrates the historical analysis of a rebalancing portfolio of equities and bonds.

Long-term performance of US equities, bonds and a regularly balanced 60% equity 40% bond fund 

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 too. For example, from 1994 to 2012, US dollar denominated emerging market government bonds (sterling hedged) gave a return 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 its performance since 2012.

This highlights the potential dangers of assuming history repeats itself or that asset class movements are accurately predictable in advance. The grey lines represent return series for other asset classes over the same period.

By understanding that diversification can mean missing out on the chance of very high, unexpected returns, investors can hopefully enjoy the benefits more, without a bitter aftertaste.

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.

 Adapted from "Diversification helps, but it's not quite a free lunch", John Roe, Diversified Thinking. To read the original, click here.