Portfolio Diversification: A key tool in weathering financial storms
15.03.2009

The recent media attention given to the ‘credit crisis’ suggests that the events of the last twelve months are exceptional and that we are racing into the biggest world recession since the great depression.

While there is no doubt that we face huge challenges in the years ahead it would be fool- hardy to believe that the credit crisis is an exceptional event and that we have not seen other crisis within capital markets since the second world war.

One only has to look at the very recent past to find examples of shocks to financial markets. The Dot-com collapse of 2000 resulted in the S&P Information Technology Index losing 83% of its value between March 2000 and October 2002. The events of September 11th 2001 resulted in the Dow Jones Industrial Average losing 14.30% in the immediate aftermath of the attacks. Others include the Russian debt crisis of 1998 and Black Monday in 1987 (see Figure 1: between the 17th of October and the end of October 1987 the FTSE 100 index fell by over 26%). While the reasons why these events take place and the names given to them may differ, the fact remains that they are part and parcel of the investment world and will occur with regularity in the future.

Figure 1
As a general rule, people become over exposed to certain assets classes (usually those performing strongly at a particular point in time) and in the last decade property and stocks have been the ‘darlings’ of the marketplace. Both asset classes have been severely hit in recent times with the result that individuals have seen the value of their investments depreciate considerably. Nobody knows when these market crashes are going to occur, we only know that they do occur, and occur systematically, and to protect against these events the best tool an investor has at his/her disposal is portfolio diversification.

Modern portfolio theory (MPT) was espoused by Harry Markowitz with his paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance. Put simply, the theory promotes the spreading out investments to reduce risks across many asset classes and within asset classes. Because the fluctuations of a single asset class has less impact on a diverse portfolio, diversification minimises the risk from any one investment or any one event.

A simple example of diversification is the following: On a particular island the entire economy consists of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio is completely invested in the company that sells umbrellas, it will have strong performance during the rainy season, but poor performance when the weather is sunny. The reverse occurs if the portfolio is only invested in the sunscreen company, the portfolio will be high performance when the sun is out, but will collapse when clouds roll in. To minimise the weather-dependent risk in the example portfolio, the investment should be split between the companies. With this diversified portfolio, returns are decent no matter the weather, rather than alternating between excellent and terrible.

So the key to ‘managing’ financial investments is to ensure that risk is spread across and within assets classes and to avoid overexpose to any single asset class or security within that asset class. In essence, the goal is to achieve a scenario where investments are making money for you at different times as opposed to your investments both making and losing money all at the same time. By achieving this diversity you improve the overall performance of your portfolio, as with any stock market based investment there remains a risk that the value of your investment may fall as well as rise.

The pie charts below demonstrate the positive effect of portfolio diversification for the individual. Portfolio A highlights a portfolio that has a mix of equities, bonds, cash and hedge funds. Portfolio B highlights the same portfolio with the inclusion of a further non-correlated investment. As can be seen, the inclusion of a further non-correlated investment improves the portfolio performance considerably while maintaining the same level of risk. In essence, a greater level of return can be achieved for the same level of risk provided non-correlated investments are contained within an investment portfolio. Although it is very useful to refer to past performance, it still beneficial to remember that it is not necessarily a indicator of future performance.

In summary, diversification is the key tool in weathering financial storms. As noted earlier, market collapses are part and parcel of the investment world and are best navigated through efficient portfolio diversification.

As Shakespeare wrote in The Merchant of Venice:

‘My ventures are not in one bottom trusted, nor to one place: nor is my whole estate upon the fortune of this present year: Therefore, my merchandise makes me not sad.’

Written for Guardian Wealth Management by
Fergus Walsh
Director
Appleton Capital Management