Seven Principles of Investment - No.5: Diversification offers real benefits

As a knowledgeable investor, I’m sure you have heard about the principle of diversification in investment. In my opinion, the most crucial time to have a diversified portfolio is in uncertain times where the economic outlook is weak.

What is diversification and what are the benefits?

Diversification means holding a variety of assets in your portfolio. The big idea is that if you own a single investment and it goes bust, you lose 100% of your investment fund. But if you held, say, six investments, the chance of them all going bust at the same time is minimal, assuming that they are diversified. Therefore, the level of risk in a properly diversified portfolio is much reduced.

An important aspect of diversification is to ensure that your basket of assets is non-correlated. What does that mean? It means that if one asset falls in value, it doesn’t pull the other assets down, in fact, in an ideal world, their value would rise.

An example of two correlated assets would be if you held shares in British Airways and Easyjet. Both airlines. It is likely that if an international event occurs, which causes a drop in the value of one, it is highly likely that the other will also drop in value. An example might be a sudden rise in the fuel price or the current pandemic!

To understand non-correlated assets, lets’ make a comparison between holding shares and gold. In this case, a facing correlation between the two asset classes is expected. Here’s what happened in the last eight stock market crashes in the USA. In six, gold gained value when the price of shares fell.

The most vivid example was during the housing and financial crash of 2007-2009. US Stocks lost 56%, while gold gained 25%. That’s an overall difference in the performance of 81%. I bet you wish you were holding gold at that time!

In the two periods when gold also fell, it recovered very quickly a little later.

We’ve just had a period of significant instability in the stock market. The FTSE100 has fallen from a high of 7,600 to a low of 4,900. That’s a fall of 35%, and even after a rally in recent days, it is still down 25% from the peak.

What about Gold?

What you can see is that after a much smaller fall of around 7%, the price recovered during late March and into early April. Now back to the same level as it was before the share crash. In other words, even as recently as the current coronavirus pandemic, gold shows a negative correlation with stock market prices. This characteristic can help hedge your portfolio against unexpected shocks.

Of course, there are many other asset classes than shares and gold bullion, and a well-diversified portfolio will take advantage of a broader range of investments. If you do this, then diversification will help you:

• Minimise the risk of severe losses.
• Preserve capital.
• Generate higher average rates of return.

One of the long term successes of fund management
is the Yale Endowment fund, an enormous USA fund looking after about $30bn of university money. The fund has achieved an average return of 12% pa across the last 20 years - astounding!

The main secret to their success is a well-diversified fund that is heavily weighted in alternative investments (around 55% of the fund). The alternative investments have enabled them to invest in riskier opportunities with higher returns, compensating for this individual increased risk through diversification!

Diversification is not just about having a mix of asset allocation, it is also about having the right asset allocation to include (in my view) a fair balance of alternative investments.

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