‘Don’t put all your eggs in one basket’ is one of the more straightforward proverbs to apply to investors. When investing, this suggests one should spread one’s savings into assets which don’t all go up and down at the same time.
But there should surely be a good investment case for each of these investments on a standalone basis, and how much spreading of investments is really worthwhile?
Wealth managers try to assess each individual’s financial aims and then recommend different mixtures of investments – so much in equities, so much in bonds and often types of investment too. In each investment area they try to pick the best manager of funds.
Sometimes the recommended mix is proscribed by specific investment aims but most want their savings to rise in value ahead of inflation over the long term (say 10 years) without taking unnecessary risk – what level of diversification does that need?
There are two ways to assess sensible diversifications: looking at the history of how investments have moved and alternatively looking at the academic work on portfolio theory.
The theory
In the 1950s Harry Markowitz developed ‘model portfolio theory’ and built a mathematical model which suggests that an optimally diversified portfolio would have around 20 holdings. More holdings would reduce return potential and fewer would increase risk. There is plenty about this on the web for anyone who enjoys econometrics.
I have always had issues with a core assumption of the theory – that the riskiness of a stock is shown by the correlation of its share price with the index, known as its ‘beta'. I haven’t found that makes sense in practice: while the nature of business risk varies little over time, stock betas vary a lot – generally telling you to sell stocks on risk ground after the shares have collapsed.
In my experience a portfolio of around 60 stocks offers adequate diversification – especially if those stocks are grouped into separate investment themes and geographies which avoid their investment cases relying on the same economic drivers. I have therefore had the bulk of my savings in one global equity fund.
My portfolio seems to be a much more focussed portfolio than those commonly recommended to savers – which can contain a number of different equity funds (and therefore hundreds of small individual holdings) with bonds - and sometimes ‘alternative assets’ and private equity funds - also thrown in.
The recent market transition from unnaturally low interest rates to, historically, normal interest rates has shown many diversification plans have not worked. Investors who asked for lower risk strategies were generally directed towards solutions with more bonds than equities only to find that it was the bonds that were the worst performing part of the package.
Markowitz would doubtless suggest my portfolio was over-exposed to equities, but it has been bonds which have recently shown the higher volatility as well as the awful real returns.
Some wealth managers seem to be suggesting that lowered bond prices (and higher nominal bond yields) should lead to most investors having a higher bond weighting.
High nominal yields are important for older savers, but this has to be judged against the risk that inflation persists longer term – the current fall in headline inflation tells you little about this risk.
