Portfolio diversification (“Diversification”) refers to the practice of spreading investment across a range of securities or assets rather than concentrating on just one or two. Like DCA (dollar cost averaging) diversification is intended as a risk management tool – this time spreading the risk over categories of investment rather than over time. But it’s another piece of received wisdom, so once again, James Claridge, our Senior Product Manager at OMG and all-round investment theory sleuth, went under the covers...you can also watch his webinar below.
Modern Portfolio Theory (“MPT”), says there are 2 sources of volatility or “risk”:
On the whole, investors require higher expected returns for tolerating more risk. MPT says that investors should earn a higher expected return for taking on systemic risk – because it cannot be avoided - but not for taking on independent risk, which can be avoided. But how?
By diversifying across investments; when one investment performs poorly, another might go well. So, the likelihood of more extreme events is reduced. It's just statistics, or the ‘law of large numbers’.
For example, say mining companies have a 20% chance of success and 80% chance of failure. Then, for an investor:
As a rule of thumb: 20 investments eliminate most independent risk, leaving primarily systemic risk (unavoidable) in the portfolio. Of course, there are layers of systemic risk – e.g. sector, market, economy. For example, you could diversify within the mining sector or within the Australian share market or globally across all capital markets.
We looked at Diversification across 20 smaller mining stocks, all with a long stock price history. Whilst this may introduce some survivor bias (because it excludes stocks that have failed), it may also be biased against outperformers since companies with long histories that remain small generally would not include those that have been extremely successful (they would no longer be small if that were the case!). These two possible effects may offset each other to some extent, but they have not been measured here. In any event, we believe that the principle of Diversification is well demonstrated by this analysis.
To keep the analysis simple, we’ve compared the historical performance of each of the 20 stocks individually against a Diversified Portfolio comprising all 20 stocks (investing 5% in each). Some key points:
Charts 1 to 6 below show the value of the $100,000 investment at the end of two years for each individual stock and for the Portfolio.
You can see very clearly in Chart 1 that the worst outcome for the Portfolio was better than the worst outcome for all of the individual stocks except MSV. And whilst not a great outcome (a bit under $40,000 - a loss of over $60,000 on the original $100,000 investment), the worst outcome for the Portfolio was around double or more the outcomes for individual stocks (other than MSV).
Chart 2 shows the bottom 10% of outcomes. Again, the Portfolio did better than all but MSV. However, some of the individual stocks were not so far off the Portfolio (whilst others were still a long way below).
Chart 3 shows the median – approximately half of the individual stocks had median outcomes better than the Portfolio and approximately half were worse. Interestingly, the Portfolio (and a large majority of the individual stocks) had a median outcome that was below $100,000 i.e. half of the time most of these stocks produced a loss on the original investment!
Chart 4 shows the top 10% of outcomes. Whilst a majority of the individual stocks performed better than the Portfolio, there will still 7 (35%) stocks that had a top 10% outcome that was below that of the Portfolio. This can be contrasted to the bottom 10% of outcomes (Chart 2 above) where the Portfolio outperformed 95% of stocks.
Chart 5 shows that when looking at the very best outcomes, the Portfolio underperformed all but 2 of the individual stocks, in some cases coming in well below the individual stock outcomes.
What this shows is that over a 2 year investment period, Diversification is an effective risk management tool. Sure, if we had chosen to invest in an individual stock and we selected MSV as that stock, our results at the bottom end would have been a bit better than the Diversified Portfolio. Although had we chosen any one of the other 19 stocks the result would have been worse, in many cases much worse than the Diversified Portfolio. So, over 2 year periods the historical data shows that Diversification is effective at protecting investments on the downside. But what about other investment periods?
Charts 6 to 8 show the outcomes for different investment periods. Each of these charts compares the outcome at different percentiles for the Portfolio and for the median of the individual stock outcomes. In other words, if you chose an individual stock at random, there would be a 1 in 2 chance that the outcome would be better than that shown, and a 1 in 2 chance it would be worse.
Chart 6 shows that over a 2 month investment period the Portfolio produces better outcomes than half of the individual stocks except for the best 25% of outcomes (i.e. above 75% percentile). At the bottom end of outcomes (on the right) you can see that the Portfolio is way above the median individual stock whilst at the top end of outcomes (on the left) it is way below the median. In COVID terms, Diversification “flattens the curve”.
Chart 7 shows a set of outcomes over a 2 year period that is similar in shape to a 2 month period (Chart 6), but of course the absolute values are higher at the top end (on the left) and lower at the bottom end of outcomes (on the right).
Chart 8 shows the results over a 5 year investment period. Here the Portfolio delivers much better outcomes than the median individual stock for all but the top 10% of outcomes.
Finally, what about brokerage? Since Diversification means more, smaller investments it may lead to higher brokerage and transaction costs. Does this offset the benefits of diversification? Charts 9 and 10 below show the impact of brokerage over a 2 year investment period for different investment amounts.
In Chart 9 the two lines, no fees and fees, are so close that the difference is not discernible. In this scenario, the impact of fees on an investment of $100,000 spread over 20 stocks (i.e. $5,000 in each) is not significant in the context of 2 year returns. But what about smaller investments?
However, Chart 10 shows the impact of fees for a much smaller investment amount. In this case the total investment is $1,000, which is spread over 20 stocks (i.e. investments of $50 each). Clearly, with small investment amounts the impact of brokerage fees over a 2 year investment period may be substantial.
As with most investment strategies, Diversification’s appeal will depend on your goals and attitude do risk.
Want to learn more about Diversification? Watch the original webinar with James Claridge, below.