Diversification – The Only Free Lunch

by | Apr 3, 2018

If you look back over the last few years, returns have been dismal and making a choice on where to invest has been a tough call on where you would find the best value and achieve the best returns. When offshore equities were doing well, the rand was appreciating. When local equities were doing well, the rand was depreciating. This has made it a very bitter pill to swallow for many advisors and their clients making investment calls over the last few years as investors keep trying to time their allocations correctly only to come short of this mammoth task. This has led me to recap on the point of diversification which is something we have been trying to master for many years as an advisory business in our multi-manager & multi-strategy investment solutions we build for our clients.

Having a diversified portfolio is one of the longest standing principles when investing, but what surprises me is that not many investors use this simple principle to their benefit when taking on risk in the market or when building a portfolio with their advisors. Diversification allows investors to reduce the risk in their portfolios by spreading your capital amongst various investments so that you don’t have to rely on a single investment for all your returns, and this can all be done without reducing the return in the portfolio either.

Contrary to belief, portfolio diversification works best when markets are going up and operating normally as opposed to financial crisis and bearish periods; Portfolio diversification provides less reduction during market turmoil such as in 2008 where correlations tend to increase between funds and asset classes which reduces the benefits of diversification. So, when markets fall, panic hits the market and investors turn to their gut instinct and sell as quickly as possible to recoup losses, this only exaggerates losses and all riskier asset classes tend to follow this theme which is what causes broader losses as we saw earlier this year and in previous corrections.

Due to decades of incorrect use, investors only use diversification when it suits them, as they try and time the markets by moving in and out of certain funds/shares when markets are going up or down. But the reality is that it’s a principle to be used consistently irrespective of up or down markets.

There are some key benefits to diversification:

Firstly, to minimize the risk of losses – if one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio from concentrating all your capital under one type of investment. The graph below shows the use of two investment managers that we use in some of our client portfolios and indicates the successful use of different funds which can add a lot of value when trying to reduce losses in your investment portfolio. No particular investment consistently outperforms other investments, they are best used together.

Secondly, to generate smoother returns – the blending of different assets or funds won’t give you the best return all the time, but it enables a much smoother ride when compounding your returns over the long-term. Even though I have used a shorter period, the graph below shows the successful use of this principle and how a smooth return profile can add more value in compounding your money. This can be compounded even further as an investors time horizon increases.

Thirdly, to preserve capital – rule number one, don’t loose your money; rule number two, don’t forget rule number one! The graph below shows how our Resolute Equity blended portfolio was able to minimize losses and allow for a better preservation of capital during the 2008 financial crisis. Where the All share index lost more than 40% of its value, our blended portfolio lost less than half of that. What most investors don’t understand is that during a crisis, most funds and shares will participate in losses as well; it’s the extent to how much they participate that makes a meaningful difference in the long term for an investors return.

Fourthly, the use of different investment vehicles – to diversify your portfolio, you need to spread your capital across different asset classes to reduce your risk. Normally, different asset classes or shares will perform better than others over different periods depending on a range of factors including: current market conditions, interest rates and currency markets. Some different vehicles include:

  • Share Choice: Growth, defensive, value, momentum, cyclical or non-cyclical shares.
  • Fund Choice: Active funds, passive funds, hedge funds or ETF’s.
  • Property or listed property vs private equity
  • Local vs offshore assets

The list of available opportunities to diversify are endless, which is what makes diversification a simple principle to understand, but at times, a lot more difficult to implement when getting caught up in the emotion of managing your own portfolio. My simple recommendation is to surround yourself with a team of experts who can assist you in implementing a good diversified portfolio, many investors don’t take enough advantage of this!