Clients often ask us for investment guidance about diversification – why is it so essential? How is it achieved? We are always glad when our clients bring up this important topic.
It is so important - in fact, we’ve blogged about it before - because diversification is not only the cardinal rule of investing, but also the one rule most often violated.
Perhaps Shakespeare said it best in The Merchant of Venice:
My ventures are not in one bottom trusted,
Nor to one place; Nor is my whole estate,
Upon the fortune of this present year;
Therefore my merchandise makes me not sad.
Here’s why diversification is important – and why so many investment professionals get it wrong.
Diversification and Wealth Management Strategies
If you ask people if they think diversification is a prudent strategy, most will nod in agreement. However, ask them to define a truly diversified portfolio and you’ll receive a range of answers -- most incorrect. In fact, even those who understand how diversification lowers risk tend to assume they’re more diversified than they really are – the binary opposite of not putting all your eggs in one basket.
Perhaps this is because diversification contradicts the wealth management strategies beloved by active managers; afterall, if you can use a crystal ball to accurately predict which stocks will rise and which will fall, you don’t need to diversify!
Unfortunately, the financial crisis taught many investors hard lessons about the hazards of ignoring diversification. And though the crisis may be over for now, asset classes are trending toward more correlation, further underlying the need for greater diversification.
So why do so many active managers still get it wrong?
The Whole is Not the Sum of its Parts
For one thing, adequate diversification must be viewed from an “entire portfolio” perspective – in other words, the whole is more important than its parts. That doesn’t mean, however, that the whole is the sum of its parts.
In 1952, Nobel laureate Harry Markowitz defined the need for a rigorous, systematic approach to diversification; his game-changing idea evolved into Modern Portfolio Theory (MPT). MPT defines investment performance in terms of the risk/return represented by the whole portfolio and, significantly, notes that a portfolio’s variability is not a simple average of its components.
However, a portfolio’s total return is the weighed average of its components – return is additive, risk isn’t. This means that diversification isn’t an end in itself, leading to the concept of “efficient diversification." In other words, in order to work, it’s gotta be done right.
Is Your Wealth Advisor Advocating the Right Kind of Diversification?
Efficient diversification works toward two goals:
Reducing the probability of loss
Reducing exposure to uncompensated risk
It does this by nudging you toward the center. Why?
Diversification reduces the range of result by allowing random outcomes to offset one another, across all assets in a class pulls you toward the average rate of return – and away from outliers, at both favorable and unfavorable extremes. and by reducing the costs of errors, as you have less riding on any given outcome. Of course, errors can only be identified in hindsight. Because the greater the distribution of investments
So while diversification won’t help you “beat the market” or directly increase your expected rate of return, it’ll reduce your uncertainty – and your risk. In any investment, you look for high return and low risk. Any time you get the same return while exposing yourself to less risk, you’re better off and a more efficient investor. This is what diversification can do for you.
The safety you derive from diversification may come at a price, but given the financial peace of mind it offers, it’s a bargain – a fact that the Merchant of Venice understood.