Is diversification dead?

The original version of this article first appeared in The Business Times. 

‍

When a single stock like Nvidia stands out as such a stellar performer, and the Magnificent Seven are driving much of the US and global equity market returns, you may wonder whether diversification is dead, and whether we ever needed it.

“Diversification is the only free lunch in finance.” This statement was made famous by Harry Markowitz, the Nobel Laureate recognised for his work on portfolio theory and the benefits of diversification.

Simply put, a good diversification strategy will enable you to achieve the same returns with less risk, or to generate better returns with the same amount of risk. We know that risk and return are correlated; they move together. There is no way to improve returns without taking more risk and vice versa.

Through diversification, we are able to achieve the only “free” thing in investing – that is, it enhances risk-adjusted returns, without taking additional risk. But diversification is far from easy to execute. It is hard work to implement and even harder to maintain, because our emotions and behaviour tend to get in the way, especially at times when it seems futile to diversify.

Benefit of hindsight

Some people argue that diversification is dead or at the very least, is inefficient or ineffective. They tell you that you should have just owned Nvidia, or just focused on the US, India or Japan market. But they say that with the benefit of hindsight. It is easy to have conviction when something has already happened. But we do not live our lives backwards.

Predicting the future is not something we are capable of doing. If we could do so, we would own that one stock which we know would be the best performer, and keep switching to the next best performer. But the reality is that nobody can do this; not even Warren Buffett would stake that claim.

I have yet to meet a person who owned and held Nvidia from the bottom until the recent peak. Most bought late and sold too early, and didn’t hold long enough to enjoy the full benefit of the rally. Some have even lost money on it.

Softbank’s Masayoshi Son famously sold a huge stake in Nvidia just before its parabolic rise. He missed out on one of the greatest opportunities of wealth accumulation before anyone even considered Nvidia. If a seasoned investor like him can make a misstep, what hope is there for most individual non-professional investors?

Diversification, therefore, is an admission that the future is inherently unpredictable. The more overconfident an investor is, the more concentrated the investment will likely be, and riskier. When diversification is done well, it provides protection against the uncertainty and the emotional roller-coaster ride that investing often is, especially over longer periods. I am talking decades, not days.

History teaches us that the benefits of diversification should be measured not in days or months or just a year, but over many years and even decades to understand the full impact and the positive benefits of diversification. If we are investing in the stock market, we are actually all long-term investors. Bonds and other investment products have finite lifespans, but equities are a perpetual investment, and are most closely matched in duration with our own lives.

If we think about it, we have many decades ahead of us as investors. I have been working in the industry for more than three decades now and I am over 50. If I live until 90, which is a high probability these days, I have only just crossed the halfway mark with more decades to go.

Diversification can be done in many ways, but the most important concept to grasp is that you must diversify across asset classes – and not just across a few stocks as markets decline frequently and could wipe out your portfolio returns. Diversification enables you to limit the losses and recover over time.

This is why the concept of maximum drawdown is critical in diversification. Each asset class or investment has a historical maximum drawdown (or fall from peak to trough). For most assets, especially stocks and real estate, that is likely to have been during the Global Financial Crisis of 2007-8, when stock markets fell by more than half.

US equities maximum drawdown and performance of other asset classes during four historical periods

‍

‍

But other asset classes such as real estate and commodities also fell, as they are, surprisingly, pro-cyclical assets. The asset classes that did not fall during the crisis and actually did well were fixed income, especially US Treasuries, gold and the US dollar – these strengthened and generated positive returns. The low or negative (moving in opposite direction) correlation between asset classes is the most important and critical component of diversification.

Of course, you can still take advantage of diversification strategies within equities.The level of concentration represents how over-confident you are. When you are diversifying, you have multiple factors to look at, not just across asset classes, but also across geographies, sectors and size (such as small-, mid- and large-cap stocks). There is also diversification across factors (such as growth versus value) and managers, with the latter being relevant when you are selecting fund managers and strategies.

You may also diversify across alternative asset classes using lower-volatility strategies, including hedge funds or private equity, which takes advantage of illiquidity premiums.

Uncertainty

There are benefits to diversification, especially when markets are at all-time highs and the future is uncertain.

Today, uncertainty arises from many issues, including the US presidential elections, multiple wars and trade conflicts. This is not a time to trade on your gut feeling, or worse, on your friend’s recommendation.

This is the time to go back to proven and evidence-based investment processes that have stood the test of time and multiple crises. This is the time to revisit diversification. Writing it off will come at a very high cost for investors.

‍