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Diversification - what's the point?

Diversification is widely regarded as one of the few free lunches in financial markets.  Investors often hear that they should diversify portfolios to reduce risk – but how can financial advisers explain in simple terms what diversification means?  In this monthly commentary John Berry looks at how advisers may want to think about the benefits – and any costs – of diversifying a share portfolio.

Thursday, November 13th 2014, 10:32AM

Diversification is best summed up by the old adage “don’t put all your eggs in one basket”.  Spreading risk is an easily understood principle.   But it is one thing to explain a principle and another to show investors how implementing this in practice can help their portfolio. 

What is risk?

Risk is an unavoidable part of investing.  Before thinking about diversification reducing risk, we should think about what risk itself means.  There are two different definitions of risk that are helpful here.  The first comes from Ben Graham – the legendary value investor.  He described risk as “the probability of not getting your capital back”.  That is how most retail investors in NZ approach risk – what are my chances of facing a total loss?  In this article we will call this “catastrophe risk”.

A second view on risk comes from Harry Markowitz, the Nobel prize winning pioneer of modern portfolio theory. He described risk as the volatility of return – this has little to do with the loss of capital.  Volatility as a measure of risk is familiar to fund managers, advisers and analysts – but is not how retail investors approach risk.

Markowitz also distinguished between “systematic risk” and “non-systematic risk”.  Systematic risk cannot be mitigated by diversification.  These risks include interest rate changes, war, recession and political change - which impact entire markets and not only individual companies.  If you are invested when markets are dealing with significant political change (a systematic risk) there is nowhere to hide no matter how diversified your portfolio may be.  In this article we focus on how diversification can help mitigate the effects of non-systematic risk.

A useful analogy to explain diversifying

A simple example of spreading risk and quantifying the benefit is to look at the early traders on the Mediterranean – the Greeks and Phoenicians around 1,000 BC.  One of the greatest fears for a merchant transporting cargo between ports was the ship sinking in a storm.  The simple answer was don’t send all your stock on one ship and risk total loss.  If you spread it across 5 ships and one sinks, 80% of cargo still arrives.  Simply put, spreading the risk to minimise loss is the benefit of diversification.

How can investors avoid catastrophe risk?

For equity investors catastrophe risk can result in total loss – a share value can go to zero.  This is a real risk which may happen as a result of corporate fraud (Enron in the US, Plus SMS Holdings in NZ),  business model failure (Lehman Brothers in the US, Blue Chip in NZ), excessive cash burn (plenty of biotech and tech company examples) or questionable asset values (OPI NZ).  There are a multitude of possible reasons.

When a company’s share value collapses, there is no insurance policy to protect the investor.  This is where the need for diversification kicks in.  If more than one share is held, the portfolio suffers pain but not complete catastrophe if one company fails.  Below we show the benefit of diversifying from one to two companies where NZF Group (suspended from trading on NZX) goes to zero and another holding (Michael Hill) increases its value.  Even with only two holdings, diversification can provide significant protection:

The blended portfolio achieves two goals at the same time.  Firstly it reduces the chances of catastrophic failure of the portfolio.  Secondly is reduces portfolio volatility.  This covers both our definitions of risk. 

How diversified do I need to be?
Our example of two stocks in is not a diversified share portfolio.  How many do we need to hold?  Below is not a scientific look at portfolio diversification but rather a quick review of how a few fund managers and brokers apply diversification in practice.
For NZ-only portfolios we see First NZ Capital (diversified income model), Fisher Funds (NZ Growth Fund) and Craigs (Core NZ model) hold 12 to 20 stocks.  Including Australian stocks we see funds managed by Devon, Milford and Mint hold 35-38 Trans-Tasman equities.  And for global stocks Pathfinder’s niche water fund holds 60 stocks, it’s broader World Equity Fund has exposure to 5,850 companies and PIE’s global fund has 500 exposures.  In short – the bigger the investment universe (NZ vs Trans-Tasman vs global) the more stocks you must have exposure to for true diversification.

Fund manger/Broker Fund/Model Portfolio Number of stocks
FNZ Diversified Income 12
Fisher Funds NZ Growth 17
Craigs Investment Partners Core NZ 20
Devon Funds Trans-Tasman 35
Milford Asset Management Dynamic 38
Mint Asset Management Active Equities 38
Pathfinder Global Water 60
PIE Funds Global Small Companies 500
Pathfinder World Equities 5850

Can diversification cost me?

There are no truly free lunches in financial markets – every apparent “freebie” has a cost.  In the case of diversification this is an opportunity cost (i.e. not a cash cost).  By diversifying across many stocks the portfolio return will be the weighted average of stocks held.  This must be less than the return of the best performing asset – this is an opportunity cost (the flipside of course is that the portfolio return will be better than the worst performing asset).  Giving up the opportunity to achieve the return of the single highest performing stock is a small price to pay for avoiding catastrophic failure of the portfolio.

John Berry
Executive Director
Pathfinder Asset Management Limited

Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.

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