Four ways to construct a more diversified portfolio
It’s sometimes hard to know the provenance of investing’s best known sayings, but the excellent term “diworsification” is usually credited to Peter Lynch. In his 1989 book One Up on Wall Street the ex-Fidelity fund manager made it clear that the wrong kind of diversification was a bad thing.
In context, Lynch was talking about the problem of companies that spread themselves too thinly. He preferred simplicity. He didn’t like firms that maxed out their time, energy and resources on non-core activities, often for depleting returns.
In the years since then, diworsification has come to mean much more to investors — but the spirit is still the same. These days it refers just as much to diversification in an equity portfolio as it does to company activities. And it’s a term that often crops up when commentators talk about risk. You see examples in articles from legends like the late Jim Slater to the present day investing great, Terry Smith.
With the end of the tax year in sight, it’s reasonable to think that many investors are reviewing their portfolio holdings. So this this week I’m exploring some of the issues around diversification and ways to think about spreading exposure in a portfolio.
Diversification 101
As a subject, diversification divides opinion. Modern portfolio theory (MPT) argues that portfolio risk can be adjusted by diversifying across a higher number of stocks. That tallies with the general message from the finance industry.
Yet, even a brief look at some of the strategies of great investors suggests that smaller, high conviction portfolios are sometimes preferable. Warren Buffett, the famously successful investor, once remarked that: “Diversification is a hedge for ignorance. It makes little sense for those who know what they’re doing.”
So how can these two perspective be reconciled? The answer, according to some research, is that most investors should diversify more. But there’s also a subset that can get away with smaller numbers of holdings because they genuinely have an edge.
This was the finding of a well known study that examined the diversification choices of 60,000 individual investors at a U.S. brokerage over a six year period in the 1990s. Importantly it looked at the covariance, or correlation, structures of those portfolios to assess diversification on two levels: A) the risk reduction due to holding more than one security, and B) the risk reduction due to choosing imperfectly correlated stocks (ie. stocks that tend not to move together).
To cut a long story short, the researchers found evidence of the former but not of the latter. They found that investors were under-diversified overall. And the problem was greater among younger, low-income, less-educated and less-sophisticated investors.
They also managed to link under-diversification to behavioural flaws like overconfidence, trend-following and local bias. Plus they found that investors who over-weighted stocks with higher volatility and higher skewness were less diversified.
The twist, as I mentioned, is that the research found that while under-diversification is costly to most of us, a small number of investors under-diversify because they genuinely appear to have ‘superior information’.
So there is a tendency for regular investors to under-diversify. But rather than simply adding more stocks to a portfolio, it could be worth considering wider options that will genuinely balance the exposure. Here goes...
1. Size matters
Diversifying between small, mid and large-cap stocks has been a key tenet of Ed’s widely-followed, factor-based NAPs portfolio. His equal-weighted, 20-stock portfolio also diversifies between sectors. But the all-cap exposure was introduced as a prudent measure, and it’s proving effective.
One argument in favour of spreading cap exposure can be seen in the returns from two of the UK’s main indices last year. In 2017 the UK’s large-cap FTSE 100 index produced a 7.1 percent return. But the smaller-cap top 100 companies in the Alternative Investment Market achieved a superior 31.9 percent gain. Those returns tell the story of a year when small-cap companies produced some stunning profits for investors.
While smaller firms often carry more idiosyncratic risk, they are less susceptible to macro factors and benefit when the domestic economy is growing. But as we saw shortly after the EU referendum in June 2016, larger companies can be a much safer option to fend off the impact of market shocks. Back then, the tumbling value of sterling meant the international earnings power of UK-quoted blue-chips was suddenly much greater.
Click here to read more about all-cap diversification.
2. Sectors that zig and zag
Quoted companies are categorised based on the sector they fall into. At the top level, there are three super-sectors: Cyclicals, Defensives and Sensitives, and then 10 sectors that are divided between them.
Generally, Cyclical sectors tend to be more sensitive to macro trends and the health of the economy and consumer confidence. But they’re still a pretty diverse bunch - ranging from mining to retail to banking. By contrast, Defensives are often less reliant on the economy because they sell goods that we buy in good times and bad. They include drug companies and tobacco and utility groups. In between are the Sensitives, which move with the economy but to a lesser extent than Cyclicals.
One of the most notable sector rebounds in recent years has been mining. It showed how out-of-favour cyclicals can suddenly come racing back. Falling commodity prices forced investors to flee in recent years, and the sector hit a nadir in early 2016. But since then many of these stocks have racked up some incredible gains as the sector pulled off an impressive cyclical recovery.
Click here to read more about sector diversification.
3. Avoiding home bias
Research consistently shows that investors in all parts of the world tend to be exposed very heavily to their home markets. This ‘home bias’ is understandable given that humans naturally stick to what they know - and where they know.
However, the UK stock market only accounts for around eight percent of global market capitalisation. So a truly diversified world portfolio would theoretically include more than 90 percent in foreign holdings. In practice of course, more than 70 percent of earnings from FTSE 100 companies (and 50 percent from FTSE 250 companies) come from abroad. So there is some natural foreign exposure in the FTSE 350.
In addition, research shows that markets in some major countries actually perform like specific sectors of the world stock market. In the UK, the market maps very closely to the Financial, Energy & Telecoms sectors. As a result, a portfolio of domestic stocks - even if appears to have broad sector exposure - could be far less diversified than expected. One solution is to take a ‘world view’ when it comes to diversifying between sectors and be prepared to look beyond borders for the best value or growth opportunities.
Click here to read more about international diversification.
4. Managing volatility
Last year - 30 years after the 1987 market crash - we reflected on ways of understanding the impact of market volatility, and how some stocks are more prone to volatility than others.
Periods of high and low price volatility tend to be cyclical. In calm conditions it’s the higher volatility stocks that catch the eye of investors. It’s these that tend to offer stronger returns when confidence is high and markets are on a roll. However, research shows that it’s the cheaper, less volatile stocks that actually often outperform everything else over time.
For these reasons it’s worth considering how volatility could impact on a portfolio. In his book Behavioral Portfolio Management, C. Thomas Howard warns against over-diversification but he concedes that it’s better for for investors to remain in the market than to be scared off by volatility. For this reason he says that “a judicious use of bubble wrap diversification can help build portfolios” that investors are more likely to stick with in good times and bad.
One option for measuring volatility is to look at a stock’s standard deviation. This is a mathematical way of understanding how much a company’s share price moves away from its average over a period of time. It’s a version of this that’s used in Stockopedia’s Risk Ratings, which uses three-year standard deviation to assign each stock a rating of either Highly Speculative, Speculative, Adventurous, Balanced or Conservative.
Click here to read more about volatility diversification.
New ways of thinking about portfolio exposure
The financial year-end is a natural time to review portfolio positioning, and that could mean looking at diversification. While spreading risk means different things to different investors, simply adding more stocks isn’t enough when it comes to reducing volatility. That kind of ‘diworsification’ is exactly what Peter Lynch warned about because it risks diluting the portfolio rather than supercharging it. So it’s essential to consider how the holdings in a portfolio are correlated and whether they offer genuine diversification.
Written by Ben Hobson, Strategies Editor at Stockopedia
Originally published at www.stockopedia.com.
Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.
