Working with the assumption that not all of our investments will perform in line with our positive expectations, and with the understanding that diversification reduces the risk of a portfolio, the question then is how do I diversify my investments? Everybody is familiar with the old adage that
“you shouldn’t put all of your eggs in one basket”
It makes sense. You should have more than one basket. Ideally you would have baskets full of eggs, carried by different people, in different places. You may even consider different types of egg. This old idiom is particularly applicable when it comes to investments. If you have your money in one investment (or bank) then you are 100% exposed to, or concentrated in, that particular place. If you spread this money out across 10 different places you have theoretically decreased your risk by 10 times. When speaking of cash held in bank deposits we may refer to this exposure as credit risk. (For example, in Japan, cash deposits in banks are only insured up to 10 million yen. If you have 11 million yen in your account, then that one million yen is exposed to credit risk). When held in investments we call it non-systematic risk (or diversifiable risk; as this is the risk that can be reduced via diversification).
How Do I Reduce Portfolio Risk Using Diversification?
On our island there are two companies, and two companies only. Company A sells rain boots. Company B sells Suncream. Investors in company A saw fantastic results when it rained but poor performance when it was sunny. Company B experienced the opposite, disappointing performance when the weather was bad, but stellar performance when the weather was good. Investing in both companies would not necessarily increase your gains, but it would help to decrease your volatility (reduce your portfolio’s standard deviation) and smooth out the returns. To receive the best results, the year-round weather has to be considered. In the same way that you do not only own one set of clothes, investors should have appropriate clothing for both sunny and rainy weather. This is the essence of diversification. Diversify your investments by holding assets that do different things.
Historically equity based investments have provided the best risk-adjusted returns. According to Credit Suisse, stock markets in the developed world delivered an annualized return of 8.5% over the last 112 years. Receiving historical averages does however have a caveat: you have to remain invested at all times (this should seem reasonable; if you wish to receive the average of a series of data-points, you are going to have to have a sufficiently large population of data. Suffice to say, if you jump in and out of the market trying to be George Soros you will limit your exposure to the market and inadvertently push yourself, no doubt lower, away from the average). As such, you should be aware that you will participate in the ebbs and flows of the business (and credit) cycle.
The average US business cycle expansion since the end of World War II has lasted 56 months. Figure 1 shows the length of expansion after each postwar business cycle peak (identified by year). The standard deviation of those 11 expansions is 35 months, which implies that there is a roughly 95 percent chance that an expansion will last between zero and 126 months. Attempting to time the stock market will invariably end in loss for the normal investor. As long as you are able to commit capital to the market over the long-term you will have historical performance averages on your side. The next consideration: where to allocate capital?
How To Diversify Your Investments – What Is The “Best” Asset Class?
The above is somewhat of a trick question. Equity has comfortably outperformed cash and bonds. Equity is the best performing asset class. However, knowing this alone will not aid in the portfolio construction process as “equity” is little more than a category, an asset class, and not any one particular investment. Historically the best performing asset class in any given year is subject to change. One year it may be US equity, the next it may be REIT’s, the year after it may in fact be Emerging Market Debt (and in this instance, not equity). There is no empirical methodology to accurately predict the best performing asset class in any given year. History has shown us that although there may be repetition across years, looking more longitudinally at return history does not allow us to extrapolate beyond saying that equity has the best inflation-adjusted returns of all the asset-classes.
How Correlation Plays A Crucial Role In The Struggle To Diversify Investments In A Traditional Portfolio
There are some impactful conclusions to be made from the above table. In a 20 year period where one category was consecutively the best-performer it only lasted for a period of 3 years. In the case of fixed income, it went from being the best performing asset class in 2002, to the second to worst performer in 2003. In fact, there is no correlation between the best performing asset class of last year and this years best performer. In fact, When considering how to diversify a portfolio of investments, it is crucial to understand the correlation between what you already have, and what you are considering adding. Any asset that you add which has a negative, or near-zero correlation to the current portfolio has diversification potential. There is no meaningful conclusion to be drawn from the best performing asset class of this year, moving into the next, so focus on your own portfolio first and foremost. The idea that the most recent condition will continue into the future is a readily acknowledged behavioral flaw in investors and is commonly referenced in Heuristics.
You may have noticed that the white squares remain consistently in the middle of the return spectrum. It will not surprise you that the “Div Portfolio” is in fact a “diversified portfolio”. Diversification means that you will inexorably never sit in the top quartile for performance. It will however, also ensure that you are also never in the bottom quartile either; and in managing excess volatility (known as variance drain) an investor will be able to achieve superior long term risk-adjusted returns to an investor who is subject to all of the markets volatility. Diversification is in fact the one tenet of personal investing that everybody seems to be in agreement on. Active Vs. Passive, Fundamental Vs. Technical, Value Vs. Momentum– all of these topical debates aside, history has proven empirically that it is best to not keep all of your eggs in one basket and that it is the person with many baskets that gets to hold onto their eggs.