We have all heard the old investment maxim – ‘Don’t hold all your eggs in one basket’. This argument suggests that by holding a wide range of investments you reduce the risk of your portfolio and improve your returns over time.

In a general sense this is true, however just like the maxim it is time in the market rather than timing of the market - it shouldn’t be followed blindly.

Firstly, lets have a look at the reasons for diversification: 

As I mentioned above, diversification can increase returns and reduce risk.

It does this principally by smoothing your returns over time so that if one part of your portfolio is suffering, positive returns on another part should compensate. This dramatically reduces the risk of your portfolio (as measured by the standard deviation).
 
 If we take a look at the ASX 200 – a diversified portfolio of the top 200 stocks on the Australian share market – we find that since 1971, the average return has been 12.1% with a standard deviation of 21.2%.

What the standard deviation figure means in practice is, that two thirds of the time your returns will be within 21.2 points of the mean return (i.e. – 9.1% to 33.3%), and 99.7% of the time your returns will be within 63.6 points of the mean return (i.e. –51.5% to 75.7%).  As you can see there is plenty of volatility within this straight Australian share portfolio. Keep in mind this portfolio includes the top 200 stocks, imagine how much more the volatile your portfolio would be if it only include 5 stocks?

Now, taking a look at the benefits of diversifying this portfolio across different asset classes we find the following:

A few interesting things to note from the above are:

• The inclusion of International shares and listed property has not only increased the overall returns but has also reduced the risk compared to the Aussie 'Share' portfolio
• All of the above portfolios have done very well, with high returns of 11 to 13% per annum, returns most of us would have been happy with. But what about the risk taken to achieve those returns, would have they passed the sleep test? The risk of the portfolios had significant differences. The pure Aussie share portfolio was 3 times riskier than the ‘Balanced’ portfolio, twice as risky as the ‘Growth’ portfolio and 15% riskier than the ‘Shares’ portfolio.
• The Balanced portfolio which included a 33% allocation to cash still had very respectable returns of 11.3%. Whilst many of you may have this much cash within your superannuation fund I would be surprised if many of you would have this much cash invested outside superannuation as a percentage of your total asset base.

Hopefully this has helped you recognise the benefits of diversification – in short, it can increase the returns and reduce the risk of your investment portfolio.

When does Diversification become Diworsification?

Two of the most common examples of diworsification I come across are:

• Spreading your investments over many fund managers within the one narrowly defined asset class.

For example, let’s say you want to get exposure to the ASX 200 – the best way to do this would be to invest in an index fund that invests in the ASX 200. However, something I often see is that many investors (often on the advice of their financial adviser) invest in 5 plus different fund managers who are all investing in the Large Cap Australia Share sector. Every one of those fund managers would typically hold around 30 to 50 stocks from the top 300.

Using the ‘old eggs’ analogy, all this achieves is to hold more eggs in the one basket – so if you drop the basket you are just likely to have more broken eggs.

• Spreading your money between superannuation platforms.

For example, I have come across investors who have a Self Managed Superannuation Fund, an Industry Super Fund and a Retail Super Fund on the grounds of diversification. This often comes as a result of the common misconception that if your super fund provider (e.g. Colonial First State) was to get into financial difficulty, you could lose your superannuation investments. Your super fund provider simply administers the investments that are held in trust for you – The financial health of the administrative company has nothing to do with the performance of your fund.

All this investor has achieved is to substantially increase their management costs, their paperwork and their compliance burden.

Continuing with the ‘eggs’ analogy all this achieves is that you are trying to hold the same ‘eggs’, in different coloured baskets (one of which you need to get audited every year).

What is the best way to Diversify?

The first point to make:

• Diversify your investments across assets that have a history of providing good returns – i.e. our preferred asset classes of shares, real estate and cash/fixed interest, not llamas, tax focussed forestry products or gambling at the race track.

The second point:

• The greatest benefits from diversification are achieved by investing in assets that have a very low correlation. To explain the term correlation, I will really stretch your patience with the ‘eggs’ analogy. Investing in assets with a high correlation is like spreading your ‘eggs’ across different baskets that are tied together, so if one falls so will the others.

The table below gives you an indication of the correlation between the asset classes since 1971:

A good example of the pitfalls of investing in assets with a high correlation is the recent stock market collapse. If you had a ‘diversified’ portfolio of Australian Shares, International Shares and Listed Property, all three would have been pummelled just at a slightly different pace and at slightly different times. This is because these three asset classes have a high correlation.

In contrast, a truly diversified portfolio of shares, cash and real estate would have performed admirably. The shares would have been pummelled, the cash would have given you positive returns and the real estate would have steadied the ship (depending on its location).

So now, when someone recommends that you ‘diworsify’ and reels out the old ‘don’t hold all your eggs in the one basket’ proverb you can tell them ‘don’t teach grandma to suck eggs’ and give them a good lesson on correlation and standard deviation.

If you would like to review how well your investment portfolio is diversified please contact your Hudson adviser.