12 Aug The Benefits Of Diversification
The Benefits of Diversification
Most investors are familiar with the concept of diversification. We know that if we put all our eggs in the one basket our returns will experience high volatility, but if we spread our investments across several different assets we’ll enjoy reduced volatility of returns. In fact, diversification is such a key component of equity investing that the Cambridge Dictionary even refers to the Stock Market in their definition of ‘diversify’ – “People are advised to diversify their investments in the stock market to reduce risk”.
But did you know that diversifying your portfolio can also increase overall returns?
Consider the following example of 2 different portfolios:
- Portfolio 1 contains just 1 asset, with an annual return of 5% per year.
- Portfolio 2 contains 5 different assets, each with a different annual return, but the same average return – 5% per year.
Over a 25-year period, you would expect these two portfolios to have the same return since each has the same average annual return of 5%, however, due to the power of compounding, the reality is quite different.
- Portfolio 1 ends at $1,693,177
- Portfolio 2 ends at $2,317,334
Portfolio two will benefit from compounding more than portfolio one as the higher compounding in asset 4 (7.5%) and asset 5 (10%) will more than offset the lower compounding in asset 1 (0%) and asset 2 (2.5%).
“By adding stocks from different industries and sectors we will be able to find investments with lower correlation.”
The Concept Of Diversification
The problem we often find is that investors do not fully understand the concept of diversification. To achieve a reduction in volatility by holding different investments, you must actually hold different investments. For example, if you held a portfolio of just two shares and those two shares happen to be CBA and ANZ, how diversified would you actually be?
We can measure diversification through a mathematical technique known as correlation. Correlation is a measure of how two different things move together. It is simple to calculate using the excel function CORREL. Correlation operates in a range of -1 to +1. A correlation of 1 means your two investments are perfectly correlated (a 1% gain in one asset is equal to a 1% gain in the other) and a correlation of -1 means the two assets are perfectly non-correlated (a gain of 1% will result in a loss of 1% in the other). Calculating the correlation of CBA and ANZ gives us a result of 0.76, a strong positive correlation.
As you can see, holding CBA and ANZ offers very little diversification benefit to your portfolio as they are so highly correlated. By adding stocks from different industries and sectors we will be able to find investments with lower correlation.
So, instead of looking at CBA and ANZ, why don’t we look at CBA and BHP. Here we find the correlation between these two to be -0.09. That is pretty close to zero and as such is achieving diversification to us to a certain degree. It is definitely better than holding CBA and ANZ.
But could we find shares with negative correlations? That would be ideal to reduce the volatility in portfolio returns.
“Most Australian investor portfolios are not well diversified.”
Finding negative correlations within the Australian share market is fairly difficult because we do not have the breadth of industry required. But we can find different industries by looking to overseas markets.
Suppose we looked to the US market and the technology sector and selected a company we all know, Apple (AAPL). The correlation between CBA and AAPL is -0.31 using data over the last 5 years. That negative correlation is important to an investor looking to reduce their volatility of returns.
There really is very little benefit to an investor in holding both CBA and ANZ. Holding twice as much of just one of them would be almost the same as holding both. But by holding CBA and AAPL we have assets that tend to move opposite to each other more often than they move in the same direction.
In the real world, the correct way to build a portfolio is to start with a universe of stocks we believe can outperform in the long term. Then we need to start looking at the correlation between them. Building a correlation matrix is the best way to do this. Start adding stocks to the matrix and if by adding a stock it does not reduce the overall correlation, then adding that stock does nothing to help your diversification and you should move on to the next one.
Research has shown that the ideal number of stocks to hold in a portfolio is around 20. The problem for Australian investors is trying to find 20 stocks with negative correlations to each other. But it becomes much easier if you add in some equities from overseas markets. According to research by S&P Dow Jones Indices and using data from January 2000 to September 2014, the Australian market is only slightly correlated with the US market. The correlation between the ASX200 and the S&P500 is just 0.14 as can been seen in this chart.
In summary, most Australian investor portfolios are not well diversified. Holding a few banks, a couple of resource companies and the odd health sector company is well below ideal diversification levels (you can check this yourself by using the CORREL function in Excel). Fortunately, there is an easy fix – by investing in US technology companies. Pick out your favourite US technology companies and then check the correlation between them and your other holdings. Adding those companies to your portfolio will reduce your portfolio correlation and will make a big improvement to the risk/return profile of your portfolio.