Opinion: To Diversify Or Not To Diversify

Josh Callaghan, Canstar’s General Manager of Wealth

Diversification. Regularly referenced, somewhat understood but rarely examined practically leading some to think their portfolio is diversified when in fact, they may just own a lot of assets with similar risks.

What is diversification?

First though, let’s unpack the idea of diversification a little by considering two stocks. I have $1000 to invest and with just two stocks in my universe I could either choose to buy $1000 worth of one of those stocks or $500 of each (or any combination in between, but let’s keep it simple).

Let’s say that after a year Stock 1 goes up 10% and Stock 2 goes nowhere and returns 0%. Here’s the potential table of outcomes:

Value after 1 year
$1000 of Stock 1 $1,010
$1000 of Stock 2 $1,000
$500 of Stock 1 and $500 of Stock 2 $1,005

Quite simply, diversification averages out the returns across the stocks that you hold and is why John Neff, a successful American investor stated that “Obsession with broad diversification is the sure road to mediocrity.”

Broad diversification is essentially spreading your chips wide enough to let your winners and losers average each other out and it’s not just the number of shares you hold that represents diversification.

Consider holding ten stocks in a portfolio. If all ten stocks are mining stocks listed on the ASX then the diversification benefit of spreading your investment is almost nil. If a resources tax hits, the Australian economy tanks or a similar sector wide issue arises then all ten stocks are likely to be negatively impacted.

Now, imagine holding ten stocks again but this time you have: one ASX listed miner, one listed bank, two consumer staple , one health care, three Nasdaq listed tech stocks, a European bank and an emerging market utility stock. This sort of diversification means that if the Aussie market collapses it may only affect 50% of your portfolio with the remaining 50% being potentially unaffected by that particular issue. If the European banking sector collapses, only 10% of your portfolio may be directly affected and so on.

Why diversify?

Here’s the basic premise, concentration of great stocks may create extraordinary returns, broad diversification often provides ordinary returns. So, the question you need to answer is, do you believe you can consistently pick great stocks? Perhaps before you answer, it might be worth considering the performance of professional money managers compared to the market.

According to S&P Dow Jones’ SPIVA US Scorecard, in the US, the S&P500 index outperformed 66% of large cap funds over the past ten years and more than 92% over 15 years. What this means is that buying an index fund, such as an ETF, and holding it for that period would get your portfolio a third place prize in a competition of ten funds against professional money managers.

In Australia the numbers are a little closer (most likely due to the concentration in our local market) but the same concept applies. According to Morningstar, over the past five years active managers have returned about the same as passive while over ten years active managers have managed to nudge just ahead. Of course, when taking fees into the calculation, it’s possible that passive nudges ahead. This can be illustrated by the graph below.

Australian Large Cap equities, March 2017

So, unless you’re confident in your ability to consistently pick great stocks, diversification can be used to provide a more consistent return over time by reducing the concentration of risk in any one area.

Many eggs in many baskets.

How do I know if I’m diversified?

Here’s a useful way I think about assessing the diversification of my portfolio. It’s not perfect but it’s a good start to raise some initial considerations.

First, take your current portfolio and divvy up your percentage asset allocation between asset classes such as equities, bonds and real estate.

Next identify the percentage of each of those asset classes by geographic region for example you may have 50% of your equities portfolio in Australian stocks and 50% in US.

Finally tally up your percentage allocations within equities and bonds to the following:

Sector Example(s) only
Financials Banks, insurance companies
Utilities Electricity providers, gas and water companies
Consumer discretionary Retailers, media, apparel
Consumer staples Food and beverage, essential products
Energy Oil and gas
Healthcare Hospital management, medical device companies
Industrials Defence, construction and manufacturing
Technology Software and IT firms
Telecom Internet services, phone and satellite companies
Materials Mining, forestry, chemical and refinement
Real Estate Residential and commercial

Putting the percentages to one side, you should end up with a map that looks something like this:

Example of an investment portfolio

This is just a fictitious portfolio for the purpose of illustration and isn’t a suggested portfolio. For simplicity I’ve used the sector allocations as if the Australian equities portion was an ASX200 ETF and the US was holding an S&P500 ETF.

The purpose of this exercise is to challenge your current portfolio allocations. You may find you’re very happy with it, you may also find that you’re overweight in areas that you didn’t realise. The owner of the above portfolio, for example, might be shocked to find that over half of their portfolio is invested in the financial sector.

The bottom line

Stock picking to outperform the market is a difficult task and not for everyone, but investors can manage the risks in their portfolio by diversifying. Doing so may provide a more consistent return over time by avoiding large single sector drops.

Over time, the compounding effect on consistent positive returns may be an attractive focus for investors rather than beating the market.

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Josh Callaghan

About Josh Callaghan
Canstar’s General Manager for Wealth, Josh Callaghan, has accumulated more than 15 years’ experience in banking and finance, with in-depth product knowledge across retail banking, stockbroking, life insurance, health insurance and superannuation. Josh’s experience combined with his passion for new technology and active role in the fintech community has positioned him as a credible thought-leader on the future of finance. Through his work at Canstar, Josh is striving towards a goal of creating a world where building and managing wealth is easy for all consumers.

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