Diversification

A discourse on diversification inevitably involves talk of eggs and baskets, yet I confess my breakables are rarely so carefully divided. As one of my colleagues frequently tells me, if you’re not living on the edge you’re taking up too much room. I go further: my entire grocery shop is fearlessly thrown into the one and same basket. Indeed, there is a rash absence of diversification permeating through my entire existence. A properly diversified life would involve at least fifteen jobs (in assorted industries), a dozen children (always driven in separate vehicles), and one-egg egg boxes, since who would be so reckless as to place two so close together? Diversification is an alien concept to our daily lives, so why should we pay it heed in our investments?

The religion of diversification preaches that building a portfolio with diverse investments reduces risk: if one venture fails, it will be compensated by another that succeeds. Diversification mutes the impact any one holding can have on the overall portfolio, and so a diversified portfolio is unlikely to hurtle downwards (or upwards, for that matter). It is moderation by design. Thus a portfolio of ten pharmaceutical companies is more diversified (and so less risky) than a portfolio of just one, though is less diversified than a portfolio with ten companies spread across a wide range of sectors.

A change is as good as a rest, so let’s take bond markets. The greatest risk for bondholders is default: the inability of the borrower to repay. Owning the bond of just one issuer exposes an investor to high “company-specific” risk: that is, the risk that this particularly company unexpectedly defaults. However in aggregate the risk of default on AAA-rated corporate bonds is pretty low – historically around 0.5%. By owning hundreds or even thousands of bonds, default risk is mitigated since even if one issuer defaults, the loss is more than offset by the return from the other bonds in the portfolio.

Every UCITS fund has strict minimum diversification criteria to meet – individual holdings may be no more than 10% of the fund, while all holdings of more than 5% must add up to less than 40%. However, understanding diversification is very much more than mathematical conditions. In isolation these rules do very little to create diversification and it is very easy for a determined fund manager to create a one trick pony. With too many eggs in the basket it is all too easy for one to finish up on your face.

We do caution, however, that there are dangers of over-diversifying. Diworsification (to borrow the word from the great Peter Lynch) is an easy trap to fall into. By owning multiple funds with diverse styles, each of which will themselves own a diverse range of investments, an investor is at risk of recreating a blancmange of the entire market. In this case, you would be better off with a cheaper index tracker. A mutual fund with several hundred companies may well have diworsified away the skill of the manager, yet still charges a premium fee. Diversification is like fine wine: a little bit can make you merry, but a lot soon becomes nonsensical. Indeed, it has been estimated that once a stock portfolio reaches 20-30 holdings, much of the “company-specific” risk has been mitigated and there is little additional benefit gained from adding even more favourites.

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