Why Diversify?

The Financialist • Issue 90 • July 2006
BY ALAN KOTAI

Diversification is a relatively easy concept to understand.  However, putting it into practice is not as simple.  Human nature creates certain biases through misconceptions of risk (volatility) and reward (investment returns), resulting in poor investment decisions.

For instance, investors have a tendency to concentrate their portfolios in investments that have performed well recently, or will chase the previous year’s "winners". Investors fail to rebalance their portfolios periodically or stick to a systematic application of diversification strategies. Often, the result is that investors will unknowingly take on higher levels of risk and only be aware of their exposure when it is too late, having sustained losses they were not prepared for.

DIVERSIFICATION: DEFINED

The old adage, "don’t put all your eggs in one basket" has been used in popular press to provide a simple definition of diversification. In more precise terms, diversification means, "Allocating your financial assets in various classes, sectors and regions to reduce risk and achieve consistent investment results."

Diversification strategies do not just apply to one’s investment portfolio. These strategies can also be applied to other components of your financial portfolio, such as structuring your mortgage to have both a variable rate and a long-term fixed rate to reduce interest rate risk.

However, for the purposes of this article I will focus on discussing diversification as it pertains to investment portfolios.

AN HISTORICAL PERSPECTIVE

By studying the past, we know that the key to long-term investing success is good diversification.

Historical Asset Class Investment Returns

To provide perspective on what has happened historically in various asset classes, we have included charts on pages 4 &5.  The large chart displays investment returns from various asset classes over the past 20 years (December 31, 1986 to December 31, 2005).  Each year is represented by a column, and the top performing asset class in a particular year appears at the top of the column, descending to the lowest performing asset class at the bottom. The chart uses equity and bond indices of various sectors and geographic regions as proxies for investment performance. Real estate as an asset class is not represented as there is no meaningful global real estate index dating back 20 years.

There are some basic observations you can make by reviewing the chart:

• Equity investments tend to have the greatest variability of investment returns.  Variability of investment returns is a common measure of investment risk. The greater the variability, the higher the risk.  An example of a risky asset class is Emerging Market Equities. From 1994 to 2002 there was only one year where performance results were exceptional, and 6 out of 9 years were negative. However, from 2003 to 2005, Emerging Markets had tremendous results.
• Fixed income investments have had relatively stable results with few negative years.  The best example would be Canadian Bonds. Over the 20 year time period Canadian Bonds have lost money only twice. In certain years, Canadian Bonds were top performers, such as years when there was an economic downturn or financial distress in the global markets. Otherwise, Canadian Bonds have had a low level of variability but with lower overall returns.

What can we conclude? There is no discernible pattern in the chart that can be used to predict future investment returns.  Despite the excellent performance of Emerging Markets Equities over the past 3 years, there are too many variables to make a reasonable assessment of whether or not the top performance will continue. This logic can be applied to any asset class.

Performance Analysis

So far, these observations have been simplistic but meaningful. We will now go one step further and provide you with a comparison of what the results would be if, over the same 20 year period, you employed 3 distinct strategies:

1. Chasing the winners: At the end of each year, you sold your existing portfolio and bought the top previous year’s performing sector to be held for the next year.
2. Chasing the losers: At the end of each year, you sold your existing portfolio and bought the poorest previous year’s performing sector to be held for the next year.
3. Diversification: Held each asset class equally weighted over time and rebalanced each year.

Here is what was concluded from this analysis:

• The Diversification strategy out-performed the other two strategies.
• The worst strategy was "Chasing the Winners".
• Both the Diversification strategy and the "Chasing the Losers" strategy had significantly less volatility than "Chasing the Winners".

WHY DIVERSIFY?

While future investment returns are unknowable, what we do know is that diversification will reduce the investment risk and deliver more consistent investment results. A sound diversification strategy takes the guess work and emotion out of making investment decisions. It is important to periodically review your portfolio to ensure that the strategies that are in place are still relevant and effective.