Nobel laureate Harry Markowitz once said: “Diversification is the only free lunch when it comes to investing.” It’s difficult to argue with a Nobel prize winner. Still, what might be missing in much personal finance and investing discourse is a conversation about quality diversification rather than diversification for diversification’s sake or, using the term coined by legendary investor Peter Lynch, “diworsification” to describe being overdiversified or badly diversified within a portfolio.
For example, an investor could have a 20-stock portfolio pitched against a standard MSCI World ETF covering 23 developed-world international markets and comprising 1,300-plus stocks. There is no contest in terms of diversification. However, not many investors stand back and question the expected risk-reward opportunity between these two options. The 20-stock portfolio might be the better investment from a risk-reward point of view. In other words, it achieves the required rate of return despite not being as diversified as the ETF option.
The above example can be applied to every broad market ETF or unit trust, compared with picking specific individual investments. Too little time is spent discussing an investment’s return vs plumping for a wide mix of stocks or bonds via an ETF or unit trust and being diversified. Taking the diversified approach does reduce the chances of something totally blowing up in a portfolio. However, a 20-stock portfolio can be equally weighted so that no single holding is more than 5% of the portfolio, and the 20 individual stock holdings can be spread across various market capitalisations, geographies, industry sectors and styles, giving an adequate diversification level.
This line of thinking is not limited to the equity space. For example, RSA retail bonds currently offer 10.25% over five years; let’s assume that over those five years, inflation is maintained at an average of 4.5%. So RSA retail bonds, guaranteed by the South African government, are projected to deliver a real rate of return of 5.75% over the next five years. Plus, there are no fees to be charged over the five years of the investment. Now compare that with a broadly diversified bond fund of South African government debt, which has a fee attached but is more diversified than owning just RSA retail bonds. The bond ETF might not be able to deliver a similar risk-return profile, though you have diversified exposure.
Recently, the FM wrote about why Japan is looking attractive as an investment destination for the first time in many years. Warren Buffett has now taken significant stakes in some major Japanese conglomerates. It’s doubtful that while sitting in his office in Omaha, he mused: “It’s better to be broadly diversified and we don’t have any Japanese exposure, so let’s add some Japanese stocks to diversify Berkshire Hathaway.”
Still, what might be missing in much personal finance and investing discourse is a conversation about quality diversification rather than diversification for diversification’s sake
No, he saw suitable investments that could deliver his required return rate. That these companies were based in Japan, and that buying them provided additional geographic diversification to a primarily US-centric business in Berkshire Hathaway, was not a driving force in the decision. Instead, it was a byproduct of the investment decision. The diversification tail didn’t wag the investment dog, so to speak.
The other problem with many indices is that while they are broadly diversified in the number of stocks or bonds they hold, they can actually be quite concentrated. Take the MSCI World ETF as an example. Looking under the hood, investors will find that of the 1,352 constituents that make up the index, the top 10 stocks represent nearly 23% of the total index. So, what happens with these 10 stocks will significantly affect the index’s performance. Looking at the geographic diversification across 23 developed-world international markets, the index comprises 72% exposure to US companies, leaving only 28% of the total index exposed to companies from the other 22 countries.
The key point is that investors must be far more circumspect about blindly following the marketing mantra that ETFs or unit trusts give them broad diversification when constructing a portfolio. What if, precisely because of the broad diversification, an investment fails to, or actively inhibits the ability to, get the desired returns? Or is the stated broad diversification an illusion?
Investors must first ask themselves what return they are trying to achieve. Once they have answered that, they should look at the best risk-reward option to achieve this. While they may not end up with an ETF or unit trust with hundreds of stocks or underlying bonds and a much-vaunted diversified portfolio, they may still be sufficiently diversified to achieve a better risk-reward outcome.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.