Diversification – Can you have too much of a good thing?

Diversification – Can you have too much of a good thing?

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Scanning one of the articles in a trade weekly this week I came across an article suggesting that amid the ‘uncertainty’ and ‘volatility’ that ‘most analysts expect’ over the coming year, this could pose a problem for those managing portfolios for their clients.

I always find it amusing when people make assertions that ‘markets are currently uncertain’ and that ‘volatility is expected’.  My reading of history suggests that the future is always uncertain.  While plenty of people are willing to make predictions and some are occasionally correct, plenty of others make what turn out to be hopelessly inaccurate predictions which are mercifully forgotten very quickly.  No doubt they seemed sensible at the time. 

Given this difficulty in making reliable predictions, the prices of publicly quoted assets in a free market economy are also always volatile, based as they are on investors’ expectations of the future.  With a large number of investors all trying to identify the best price at which to trade, it should not be surprising that those prices vary a lot in the short term.  If the future were reliably predictable and prices reflected that, the risk of loss would be much lower but so would the returns because the two are related.

Anyway, the point of the article was to highlight the benefits of diversification in portfolios.  We are big fans of diversification.  As I said above, risk and return are related but diversification has been described as ‘the only free lunch in investing’ in that it enables a portfolio’s returns to be enhanced without increasing its risk.  Indeed it can enable returns to be increased while simultaneously reducing risk.

The basis for this seemingly improbable outcome is correlations.  For those not of a statistical inclination, this is merely the extent to which two or more variables (in this instance, the change in the price of an asset) tend to move together or not.  The chart below are two hypothetical businesses, such as the manufacturers of sun hats and snow chains, whose fortunes vary with the seasons.  While they both have the same return over the period, the experience for any investor who held only one of them would be fairly exciting.  Someone holding both in equal proportions however, would have a much smoother ride as the fluctuations even each other out.

 


Source: Bloomsbury Wealth

Obviously this is an idealised example and if it were that easy, the savvy investors would time their ownership to maximise returns by buying and selling each at the turning points.  Yet real life is not so easy and those turning points are invariably less obvious until afterwards.  History suggests that many people would try to time them and fail miserably, thus not even achieving the return of the idle investor who did nothing.

However, it is possible to have too much of a good thing?  Can a portfolio actually be too diversified?

The ultimate diversified portfolio is basically the entire market of assets.  If you own everything investable in proportion to its value, then you own the market.  There are obvious practical difficulties to this in that some assets are not investable (for example, most businesses are owned privately and are also far too small for external investors to own a tiny percentage of them) so in reality it is necessary to limit diversification to what is cost-effective to achieve.

An easy and cost-effective way to start the process is by owning funds rather than individual securities.  While you can build a diversified portfolio by buying the latter, the costs of trading and the time involved make it a viable proposition only for those with fairly significant (six figures) amounts of investable capital.  By contrast, there are many funds containing hundreds of holdings which can be bought with as little as £1,000 or even less and with an annual cost of under £10.

While a fund will typically contain upwards of 30 holdings (often many more – some hold thousands), a UK investor is able to invest in thousands of funds covering almost every imaginable market segment.  It might therefore seem reasonable to expect that holding many funds will provide a more diversified portfolio than holding few of them. 

However, with so many funds available, it is inevitable that there will be a certain amount of duplication of holdings between them.  Not many UK large company funds will have no exposure to HSBC, Shell and BP so any portfolio with several UK equity funds in it will likely contain several holdings of some of the same companies across them.  Some managers will overweight particular companies where they believe that the prospects are better than the market as  a whole so holding several of those funds (even though individually they are diversified) may not contribute much to the diversification of the portfolio as a whole.

The important thing to bear in mind is that merely owning lots of things is not necessarily going to provide the most diversification.  For it to work effectively, you need to own things which behave differently.  For example, owning shares in 30 technology companies is not going to protect you much if there is another blow-up in this sector as happened in 2001.

Owning multiple funds which each provide exposure to particular market segments (such as technology, financials, oil & gas and utilities) will provide diversification across the portfolio but it may be that the same diversification can be achieved more easily (and more cheaply) with a single fund.

There is another issue with holding multiple funds with the same underlying assets, which is that from time to time, the fund managers will decide either to increase or decrease their holdings of a given company.  Since every transaction requires both a buyer and a seller and most assets are held by institutions, it is not difficult to envisage that when the manager of one fund that you hold is selling something, the manager of another that you also hold is buying it.  The outcome could be that your portfolio ends the day with a composition little different to how it started but a bit poorer as it has had to absorb the transaction costs of both transactions.

While a portfolio with 20, 30 or 40 funds might appear to be more widely spread than one with only five or six, it will be more complex to manage, probably have higher transaction costs and may actually be less diversified.