The basic theory behind diversification is to reduce risk by not putting all your eggs in one basket. It sounds simple, but it is one of the most poorly understood areas of investing.

Many people think that because they own a dozen or so shares, or a few investment properties, that they are well diversified. Conventional wisdom says you should diversify across securities (e.g. different shares), asset classes (e.g. having a mix of different kinds of investments), and time (e.g. spreading your investments across time periods, which is not hard for most investors, as they are investing progressive savings, rather than a lump sum).

For example, let’s assume you are invested in shares. Increasing the number of shares reduces the risk of any one share falling dramatically in price, but it has little impact in a share market collapse. During the GFC, even investors that had a portfolio diversified across hundreds of shares and many countries, suffered catastrophic losses, as all shares fell together – i.e. their diversification didn’t help them in this event, as whilst they may have diversified well “within” the share market, they could not diversify away their share market risk.

The only way to do this effectively is with carefully considered asset class diversification. The problem is, that when most people think they have diversified across asset classes, they really haven’t, as they still end up with a portfolio that is dominated by share market risk. For example, if you have a portfolio that is invested 50% in shares and 50% in bonds, 90% of the risk in your portfolio is coming from the shares. This is far from ideal; however, most investors end up locked into this situation because shares are able to produce decent long-term returns, meaning that investors that need to grow their retirement assets more aggressively than they could by putting their money in the bank, end up being heavily exposed to share market declines.

When building the portfolio that will fund your retirement, it is critical that you get the “asset allocation” decision right, as deciding how much of your portfolio goes into each asset class will ultimately largely determine whether you reach your goals, or blow up along the way. Good asset allocation rests on maximising returns for a given level of risk, by effectively diversifying your portfolio to ensure that it performs well, irrespective of future economic conditions.

What are the best ways to achieve real diversification?

  • Think carefully about exactly what risks you can and can’t reduce, and to what degree (you can’t diversify away every risk, but you don’t need to either);
  • Increasing the number of shares in a share portfolio reduces individual company risk – but not the risk of the share market itself. During the GFC, even index funds lost over 50% of their capital (remember, diversifying within an asset class, still leaves you with the risk of the actual asset class itself);
  • Combining lowly or negatively correlated investments dramatically reduces portfolio risk, as different parts of the overall portfolio will be responding differently to prevailing conditions;
  • To reduce share market risk, it is necessary to include investments in your overall portfolio that are lowly or negatively correlated to the share market, and will therefore not suffer as much (or even perform well) when the share market declines;
  • To reduce property market risk, it is necessary to include investments lowly or negatively correlated to the direction of the property market (remember, a lot of credit/lending related assets are correlated to the property market, as they are based on the creditworthiness of borrowers);
  • Unfortunately, most investments perform well under similar economic circumstances, particularly when economic growth is strong, and credit is expanding. The key to designing a better portfolio, is ensuring it is adequately balanced, and can continue to perform well when economic growth falls relative to expectations, and in the midst of credit contractions (in other words, a portfolio that can perform well in both good and bad times);
  • Seek out and include investments that are characteristically different to shares and property, to ensure the perceived low or negative correlations will hold up when they are needed most, i.e. in a rapidly falling market, and deteriorating economic conditions;
  • Seek out investments that have the ability to perform well in both rising and falling markets, and in inflationary and deflationary periods; and
  • Stress test your portfolio, using a wide range of economic conditions and specific events, such as; Black Monday, the GFC, 9/11, the Tech Wreck, Brexit, etc. (stress testing involves simulating how a current portfolio would have performed in a past financial event, focusing on calamities, or significant market moves – this helps to understand how your portfolio will perform in conditions that are abnormally adverse).

Use investments with low or negative correlation to reduce risk

In simple terms, correlation is a statistic that measures the degree to which two sets of data (e.g. investments) move in relation to each other. For example, if we had two perfectly positively correlated investments, they would move up or down by the exact amount at the same time, whereas, if we had two perfectly negatively correlated investments, they would move in opposite directions by the same amount at the same time. Let’s look at a simple example to better understand correlation:

Note: The blue line indicates positive (if slanting upwards from left to right) or negative (if slanting downwards from left to right) correlation. If the red dots are close to the blue line it indicates strong correlation, whereas if they are scattered, it indicates weak correlation.

Getting it right

When using diversification to protect your portfolio, the logic is to:

  • combine investments that each produce good long-term returns through a wide range of economic conditions, with low to moderate volatility;
  • only include investments that are not subject to severe contingent risks;
  • seek to combine investments that are lowly or negatively correlated to each other, to ensure they don’t all go down at the same time. This will reduce overall portfolio volatility; and
  • ensure the correlations will hold up, even under the worst possible conditions, by ensuring that you combine investments that are characteristically different and will therefore perform better at different points of the economic cycle, thereby ensuring that your portfolio is balanced to various economic conditions, and not simply dependent on rising asset prices.

The above may sound simple enough, and yet it isn’t, as correlations change over time, and under different economic conditions. It takes a considerable amount of time and effort to achieve the ideal portfolio asset allocation that meets your risk and return objectives. Risk can be dramatically reduced in an investment portfolio by combining lowly or negatively correlated investments, and yet, we see a staggering number of portfolios that are loaded with investments that are closely correlated.

Further, and this is a critical point, correlations MUST hold up, even under the worst possible conditions. Many people invest in shares in different sectors, or in different countries, or buy properties in different states, in the belief that this will protect them, however, in the GFC, all shares went down together, and in general property market declines, all properties will likely decline together (although to differing extents), so the diversification benefits are lost – when they are needed the most.