The case for diversifying your portfolio

Miguel de Cervantes, author of Don Quixote, may not have known much about finance, but his recommendation not to put all your eggs in one basket has been enthusiastically adopted by investment experts everywhere. “The only free lunch in finance” was Nobel Prize winner Harry Markowitz’s endorsement of diversification.

Diversifying your portfolio means spreading risk by having a range of investments – different types, asset classes, sectors and geographical areas – which can be expected to respond to different events in different ways.

However, the past few years have been a poor advertisement for spreading risk with a diversified portfolio. Investors could have bought some technology companies and some government bonds and bagged a healthy return. So why worry about diversifying?

There are some compelling arguments to holding diversified investments, rather than just trying to pick one winner. From the general unpredictability of markets to the difficulty of market timing, there are numerous reasons why diversifying is a good idea.

You don’t know what is round the corner

At the start of 2020, many leisure and travel businesses appeared to have a bright future ahead of them, while many technology businesses were considered too expensive. The pandemic sent everyone’s calculations awry. Few could have foreseen the profoundly disruptive impact of Covid-19 and its long-term consequences for individual businesses.

This time, technology benefited while leisure businesses suffered, but it is different with every crisis. The banks bore the brunt in 2007/2008 and technology at the turn of the century, while mining has also seen its boom and bust. Investors don’t know which sector will be hit by each crisis. There is also an argument that these random ‘black swan’ events are becoming more frequent. Either way, investors need to be prepared for a range of scenarios. A diversified portfolio can help with this.

You need to bring in new sources of growth

Taking exposure to areas such as smaller companies, or niche technology, or green energy is important for ‘future proofing’ your portfolio. However, many of these businesses will be early stage and high risk. Only a handful will grow into the Amazon or Apple of the future. Holding a balanced, diversified portfolio allows you to bring these new themes into your investments, while limiting your downside exposure.

You avoid market timing

For a long term investor, trying to predict when to enter and exit the market is usually a fruitless task. For the most part, it just adds trading costs and dents returns. The well-respected Dalbar study has shown year after year how investors receive a lower return than the market because they move in and out at the wrong time. It’s 2020 survey showed that while the S&P 500 Index had returned an average 9.96% over the previous 30 years, the average investor actually received just 5.04% a year. The difference? Market timing

Our human instinct to follow the herd means the average investor has a tendency to sell at times of peak ‘fear’ and buy at times of peak ‘greed’. Holding a diversified portfolio at all stages of the market cycle helps avoid the temptation to move in and out of the market with every new episode of volatility.

You have an investment for all seasons

Diversification in investing means that even in the bleakest periods for markets, you should have something in your portfolio that is doing well. If stock markets are tumbling, you may have a government bond fund that helps cushion the blow. If your technology shares are volatile, some solid, dividend-paying blue chips should be in favour. Not only does this smooth out your returns over time, it helps you sleep at night.

This ‘get rich slowly’ approach has important psychological advantages. It also helps you avoid wealth-destroying behaviour, such as selling out amid a market rout. Having a diversified portfolio makes it easier to hang on during the tough times.

But...

Diversifying doesn’t mean investing in everything

Taking efforts towards diversified investments can go too far, leading to the problem of ‘diworsification’ – investing so broadly that the positive effect of diversifying is lost. Investors may struggle to keep track of their investments, costs can spiral and they may find that some investments are not as diverse as they appeared, all of which can impact returns. Diversifying doesn’t avoid the need to pick good investments and shouldn’t stop you achieving a return that is higher than the market.

Diversification in investing is changing

It used to be that investors could rely on blending stock market investments with some fixed income and cash for a diversified portfolio. However, loose monetary policy has skewed bond and equity returns and made diversifying more complex. As such, investors need to consider correlation, whether or not two assets react to an event in the same way, more carefully and potentially bring in new sources of return – specialist property, for example, or infrastructure.

As the markets become increasingly unpredictable, it’s more important than ever for investors to hold a diversified portfolio of assets to grow wealth over time.

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