Do you know what is one of the most commonly used words for financial advisers or portfolio advisers? Bingo! It is diversification. Diversification has been the mantra for most financial advisers and portfolio advisers. What is diversification? What are the pros and cons of diversification? Is it applicable to everybody? In this article, I will seek to explore and address these queries.

What is diversification?

Assume that there are two assets A & B, whereby each of them carries a 10% chance of losing everything. You have two choices. A) You can invest 100% of your portfolio into either asset A or B and risk a 10% chance of losing everything. OR B) You can invest 50% of your portfolio each into assets A and B. If they are not positively correlated with each other, chances of losing your entire portfolio are likely to be less than 10%.

It is imperative to note that diversification is more effective if the prices of the assets in your portfolio move in different patterns or directions from one another. It is not the case of having excessive holdings into all the asset types. If I tell you that I invest a quarter of my portfolio each into cash, equity, bond and alternative fund, it would seem like quite a balanced portfolio but the devil is in the details. If I elaborate by telling you that my holdings in the different asset classes are as follows:

1. 25% in currencies limited to Australian, New Zealand and Canadian dollars;
2. 25% in shares of mining companies such as BHP Billiton, Rio Tinto etc listed in Australian Stock Exchange;
3. 25% in the corporate bonds of the same mining companies in b); &
4. 25% in a Mining Fund.

Just to elaborate on d), Australia is the leading producer of many minerals such as gold, zinc, uranium etc. Most multi national mining companies operate in Australia and are listed in Australian Stock Exchange. Furthermore, the Australian Stock Exchange has one of the most (if not the most) mining companies listed on the bourse. To quote some statistics: Almost one third of the companies listed in the Australian Stock Exchange are resource companies. Thus, for the Mining Fund to have meaningful exposure to mining companies, it inevitably will have some holdings in the Australian listed mining companies.

Thus, does the above portfolio strike you as balanced or, in fact a concentrated portfolio? Before you hazard an answer, do consider the impact of falling commodity prices on the assets a) to d). Would all of them follow a similar pattern?

The above portfolio is rather concentrated. A more balanced portfolio would be

1. 25% in global currencies ;
2. 25% in global equities;
3. 25% in global bonds and ensuring that the issuers of these bonds are not the same companies as b); &
4. 25% in a Mining Fund

Key advantage of diversification

The key advantages of diversification are as follows:

Less volatile swings in portfolio returns

An effective diversification strategy typically smoothes out portfolio returns. If you have a well diversified portfolio, it is unlikely that you can boast astronomical portfolio returns to your friends. Nor is it likely to be the worse performing portfolio where you have to hide your head in a bag when your friends ask about your portfolio returns. This reduction in the volatility of portfolio returns enables most investors to sleep well at night. In addition, it is easier to make investment decisions if your returns do not swing from wildly positive to badly negative per week.

Improve returns by minimizing losses

With reference to my assets A and B in the earlier paragraphs, it is possible that by combining assets A and B, the returns of the entire portfolio may be higher than solely investing in either asset A or B. This is because returns on the entire portfolio can be improved by reducing losses on the portfolio.

With reference to Table 1. losses can be minimized even during the stock market slump in 2008. From the table below, notwithstanding the slump in markets, yen, swiss franc, gold and bond registered positive gains for the year 2008 (rightmost column). Thus, diversification can improve returns by reducing losses.

Table 1: Percentage returns* for the different assets for different periods (Source: Bloomberg)

Good complementary tool

For example, if an investor who is not proficient about specific commodities and their price drivers, it may be better for the investor to diversify by investing into a commodity fund, instead of owning specific commodity companies stock. In addition, investors may not have access to specific companies listed in China, thus they may diversify by investing into a China Fund.

Disadvantages of diversification

Diversification does have its disadvantages if we do it improperly.

Possibility of including sub standard assets into the portfolio

A diversified portfolio typically has many different kinds of assets in different asset classes. To profess proficient knowledge in all kinds of assets is not possible. Thus, there is a chance of buying sub standard assets due to limited knowledge or limited time. This is one of the reasons why Warren Buffett advocates a focused portfolio strategy.

Limited impact on portfolio return

If you have invested equally into a hundred different assets in a portfolio (Portfolio A), it is reasonable to expect that one asset has less impact than a person whose whole fortune is tied to ten assets only (Portfolio B). Thus the movement of one asset in portfolio A is unlikely to have a significant impact to the entire portfolio returns.

Transaction costs

Further to the example on portfolios A and B, the transaction costs of buying into portfolio A are likely to be more substantial than that of portfolio B. This would have a negative impact on the portfolio returns.

Correlation patterns may break down at certain points in time

With reference to Table 1. bond prices usually have a negative correlation with that of stock prices, thus offering a good diversification option. However, correlation patterns may break down over a certain time period. For example, during the period from 1 Jan 09 to 9 Mar 09 where there is capitulation, with the exception of gold, all assets registered losses. Thus, correlation patterns do break down at certain points in time.

All boils down to your own profile

In my opinion, I do not advocate dumping all your eggs into one single stock. However, I still have a predilection to a focused portfolio and not a truly diversified portfolio. 1 I would prefer to keep a basket of high quality equities (may not be blue chips), some currencies and perhaps a commodity fund 2 etc. I will not invest in bonds. However, the extent of diversification depends on ones risk profile, return expectations, investment philosophy, areas of core competencies, transaction costs etc. Thus, as with most investment matters, there is no magical one-size-fits-all formula for everybody. Ultimately, the investor has to take responsibility and choose his investment style carefully. This is what makes investment interesting.

* The returns exclude any yields or dividends earned from the assets. They comprise of capital gains only.

1 This is mainly based on my analysis of the current investment climate, my own risk preferences and knowledge in specific counters.

2 Writer wants to have access to a wide spectrum of agricultural commodities thus, it is likely that he will gain exposure via a commodity fund.

Ernest Lim is a CFA, CA and has worked at GIC Special Investment. He has a solid feel of the markets and financial world and is now a remisier.