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It was Nobel Prize winning economist Harry Markowitz that once called diversification “the only free lunch in finance”. What he meant by this was that through asset allocation and diversification (the concept of spreading your capital amongst different investments) an investor can receive a benefit (the reduced risk) with no loss in returns.
Unfortunately, correlations (i.e. the extent to which assets go up and down together, or not) have increased over time; as we have become increasingly globalised and interconnected. Geographic correlation in particular has increased, and this has perhaps reduced the nutritional value of the free lunch Markowitz was referring to. But that doesn’t mean the benefits of diversification should be overlooked.
A brief understanding of Portfolio Risk and Diversification Benefit
When we create new client portfolios or review an existing one, we will use market leading software: FE Analytics, to produce a comprehensive report with a wide range of insightful scores, ratios and other performance metrics. Most relevant to this article are the Portfolio Risk Score and Diversification Benefit.
What is a Portfolio Risk Score?
Risk Scores provide a relative rating of the risk. The FTSE 100 is given a Risk Score of 100 and other investments are given a rating in relation to the FTSE 100. For example: a lower Risk Score would indicate the investment is of lower risk than the FTSE and a higher Risk Score would indicate that it is of greater risk. Portfolios are also assigned Risk Scores and although the basic principle is the same, this rating will also be affected by the make-up of the investments held within the portfolio.
Therefore, if you have investments in different asset classes or different areas, the Portfolio Risk Score will reflect this diversification – and the score will be lower as a result.
What is Diversification Benefit?
A diversification benefit indicates to what extent the risk of your portfolio has been reduced by this interaction effect of the investments held.
Following on from Markowitz’s free lunch adage: Any portfolio holding investments that are not perfectly correlated (i.e. that behave in different ways) will experience some level of diversification benefit. The lower the correlation the higher that benefit will be. For example: by choosing high risk but uncorrelated investments, an investor will be able to create a portfolio with far lower risk than the sum of its parts.
The Diversification Benefit cannot be lower than 0% and whilst in theory, the maximum is 100%; in reality the ceiling is nearer to 50%.
For example: a typical well diversified medium/high risk portfolio might expect to have a Diversification Benefit of c.15% (medium benefit); in contrast our Core Permanent Portfolio (designed for capital preservation investors) has a Diversification Benefit of 41% (very high benefit).
Why is any of this important?
Firstly, it is important to keep in mind that a high level of diversification does not determine whether a portfolio is good or bad. An investor may have good reason for low or no diversification. Most commonly this will be when an investor has a high conviction of which way specific assets or markets are going to perform and wants to exploit this scenario.
This will mean they have much lower diversification and could make large gains if proven right; or suffer large falls if proven incorrect. Understanding your Diversification Benefit is important to ensure you don’t receive any unwelcome surprises..
Protection against adverse markets
Investors will typically look to maximise diversification as a form of insurance when they are unsure as to which direction markets are going to move. Essentially, they want to spread their risk to avoid large drawdown events.
It would be useful to keep in mind that a portfolio where everything is going up at the same time, can also turn into a portfolio where everything goes down at the same time. That’s not diversification!
Let us help
If close to retirement or sitting on large unrealised gains you would like to protect, then it may pay to better understand what your Diversification Benefit is. We can provide you with a free report using FE Analytics software which will tell you both the amount of risk you are taking and the Diversification Benefit gained. We can also use this report to check whether your funds are performing well, or not – when compared to other equivalent risk rated investments or portfolios. Furthermore, we can identify if you are paying too much in charges – which will also impact any benefits you are receiving!
If you would like to receive your free portfolio report, or would find it helpful to have an initial conversation: please give us a call or send us a message by completing our contact form.
