The Art of Diversification

I have been looking after clients money now for nigh on 30 years and the three words that I  think are the most important words when discussing investments are’ Diversification, Diversification and Diversification.  Harry Markowitz, the American economist, is probably known as the daddy of the concept of Diversification.  In the 1950s he developed a formula for the “best” portfolio mix, or in other words, for the “optimum” diversification.  His mantra was to diversify investments  by avoiding putting all their eggs into one basket.  Instead he advocated splitting their funds across different asset classes e.g. stocks, bonds and commodities and this strategy won him the Nobel Memorial Prize in Economic Sciences.

He tried to understand the correlation between different asset classes.  We all know that markets rise and fall but the shares investors deal in do not all behave in the same way and at the same time.  For example, shares in oil companies might fall when oil prices drop, but shares in airline companies might take off (excuse the pun) as they take advantage of cheaper oil prices.

By and large, poorly performing investments can be protected by profitable investments, which in turn reduces risks across the portfolio. Hence diversification reduces risk without reducing expected returns. Alternatively, expected returns may improve without increasing risk.

Individual investors however face the difficult task of selecting the right assets for their portfolio and allocating the right proportions accordingly.  What makes it more difficult is that a portfolio should be optimised and adjusted on a regular basis as the risks of different investments change over the course of time.

Therefore, it would appear to be a good idea to get professional help. At ABFM, we advise on globally-diversified portfolios and our partners in the Investment Houses we use monitor the portfolios and ensure that the risk appetite of each client is met. They don’t necessarily rebalance a portfolio after every short-term market correction, but will adjust portfolios according to the market conditions if there has been a change to the risk environment.  Also they may well rebalance the portfolio automatically every quarter.

You should of course be aware that with every investment comes risk. The value of  an investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance.