Diversification protects your portfolio

• Level: For beginners
• Reading duration: 7 minutes

Why diversification is a free lunch

Don't put all your eggs in one basket may be a cliche, but its also the best investment advice you'll ever receive. Diversification is your first line of defence against the extreme circumstances, summed up in the famous quote:The market can remain irrational longer than you can remain solvent. In this case, the basket is your portfolio and the eggs are asset classes. Bet your future prosperity on a single position, and you risk coming unstuck, like an investor in the Japanese stock market circa 1989. Ultimately, nobody can guarantee how events will unfold. You don't want to be the cautionary tale who bet the house on tech stocks in early 2000, or went to cash during the 2008 meltdown and missed the bull market starting 2009, or put everything into Bitcoin during December 2018. Because its easy to get carried away during a bubble or a crisis, Harry Markowitz won the Nobel Prize in economics for stiffening investors resolve by turning eggs-in-a-basket adages into a rigorous mathematical model. His work showed that a portfolio of assets with varying expected returns and volatilities could be combined to reduce overall risk (or boost overall performance) for an investor. Fast-forward to today, and diversification is the big bazooka in the armoury of every long-term investor, including global pension funds and renowned US universities such as Harvard and Yale. As Markowitz said,Diversification is the only free lunch in finance.

Risk minimization through intelligent asset allocation

Diversification works on two levels. Firstly, it works horizontally across asset classes, e.g. a diversified portfolio includes equities and bonds. Secondly, diversification works vertically within asset classes e.g. your equity allocation includes many different types of firms spread across geography, sectors, size, style and so on.

Diversification across asset classes

Horizontal diversification across asset classes is the simplest and most effective way to spread your risk. This is because equities and bonds offer positive expected returns over the long term but often respond differently to the economic conditions. Equities typically outperform other assets during boom times, while high-quality government bonds are often a safe haven during a downturn and can compensate investors when stock markets fall. Moreover, if equities unexpectedly underperform for a decade, a broad asset allocation in bonds, property and commodities ensures you aren't caught with a single egg in your basket.

Diversification within asset classes

Imagine buying into Amazon in 1997. With a portfolio full of Amazon shares, you'd be rich now, no? Well, only if you could stand the 95% loss it took during the dotcom bust. Plus multiple double-figure drawdowns in the 20 years since. Amazon has been a gut-wrenching ride for its investors. And who knew Amazon was going to be the big winner in 1997? Plenty of investors bought into pets.com or the many other dotcoms that sounded like the next big thing but aren't with us today. That's why you shouldn't bank everything on a single firm. Individual securities are too vulnerable to misfortune, bad management, fraud, a change in regulation that renders it a loser. These are real, idiosyncratic risks that can be diversified away when you invest broadly enough within an asset class. The classic diversification rule of thumb for equities is to hold at least 30 positions. That rule came into fashion before funds were widespread, but nowadays, its easy to hold hundreds or thousands of securities through ETFs that track broad indices. The same logic applies to diversification across countries, regions and sectors. The poster child for country risk is Japan - its stock market has still not recovered its 1989 high watermark. But every country is vulnerable. For example, the UK stock market is highly concentrated in oil, commodity and financial companies while utterly deficient in tech firms. The UK was hit hard in 2008 when banks bore the brunt of the Global Financial Crisis. Meanwhile, oil companies will have to cope with decarbonisation for decades to come. The answer? Diversify globally - you can't spread your risks any further than that. You can also easily diversify your positions in other asset classes by using ETFs. You can invest your bond allocation globally across government bonds, corporate bonds and index-linked bonds. Furthermore, you should also consider a range of maturities and risk ratings. In commodities, you can invest in precious metals, agricultural commodities, energy and more. Investing is the best spread geographically, with bonds in all maturity bands.

Mixing risky assets lowers risk

Its not hard to see why a lower volatility asset like government bonds reduces the risk of an equity-dominated portfolio. But adding higher volatility assets like gold can also reduce your portfolios overall risk. This may work because historically the correlation between gold and equities has been low or even negative. Thus, gold can outperform when either one or even both of the more conventional asset classes underperform. You can see how this works in the chart below. An example comparison of the five-year volatility of an MSCI World ETF with the volatility of a gold ETC makes it clear that both investments fluctuate strongly, at 18.53% and 14.69%, respectively. The combined portfolio, on the other hand, has a volatility of only 12.71% (as of 06/09/2023). The low or negative correlation contributes to risk minimization.

Comparison MSCI World ETF and Gold ETC over five years (06.09.2018 - 06.09.2023)

Diversification against uncertainty

Some risks can't be captured by the models because they are unprecedented: these are the black swan events made famous by the crisis theorist Nassim Taleb. Its this uncertainty that makes diversification necessary. Do not make the classic mistake of thinking you can predict the future. Do not be tempted by the price jumps of individual stocks. After all, great opportunities are always associated with great risk, so diversify, diversify, diversify.