W
L
IS YOUR MONEY RECEIVING
A DIVERSIFICATION BENEFIT?
by Sam Hulson of First Equitable
It was Nobel Prize winning economist Harry Markowitz that once called
diversification “the only free lunch in finance”. What he meant by this
was that through asset allocation and diversification (the concept of
spreading your capital amongst different investments), an investor can
receive a benefit (the reduced risk) with no loss in returns.
Unfortunately, correlations (i.e. the extent to which assets go up and down
together, or not) have increased over time; as we have become increasingly
globalised and interconnected. Geographic correlation in particular has
increased, and this has perhaps reduced the nutritional value of the free
lunch Markowitz was referring to. But that doesn’t mean the benefits of
diversification should be overlooked.
A brief understanding of Portfolio Risk and Diversification Benefit
When we create new client portfolios or review an existing one, we will use
market leading software: FE Analytics, to produce a comprehensive report
with a wide range of insightful scores, ratios and other performance metrics.
Most relevant to this article are the Portfolio Risk Score and Diversification
Benefit.
What is a Portfolio Risk Score?
Risk Scores provide a relative rating of the risk. The FTSE 100 is given a Risk
Score of 100 and other investments are given a rating in relation to the FTSE
100. For example: a lower Risk Score would indicate the investment is of
lower risk than the FTSE and a higher Risk Score would indicate that it is of
greater risk. Portfolios are also assigned Risk Scores and although the basic
principle is the same, this rating will also be affected by the make-up of the
investments held within the portfolio.
Therefore, if you have investments in different asset classes or different areas,
the Portfolio Risk Score will reflect this diversification - and the score will
be lower as a result.
What is Diversification Benefit?
A diversification benefit indicates to what extent the risk of your portfolio
has been reduced by this interaction effect of the investments held.
Following on from Markowitz’s free lunch adage: Any portfolio holding
investments that are not perfectly correlated (i.e. that behave in different
ways) will experience some level of diversification benefit. The lower the
correlation the higher that benefit will be. For example: by choosing high risk
but uncorrelated investments, an investor will be able to create a portfolio
with far lower risk than the sum of its parts.
22 wirrallife.com
The Diversification Benefit cannot be lower than 0% and whilst in theory,
the maximum is 100%; in reality the ceiling is nearer to 50%.
For example: a typical well diversified medium/high risk portfolio might
expect to have a Diversification Benefit of c.15% (medium benefit); in
contrast our Core Permanent Portfolio (designed for capital preservation
investors) has a Diversification Benefit of 41% (very high benefit).
Why is any of this important?
Firstly, it is important to keep in mind that a high level of diversification does
not determine whether a portfolio is good or bad. An investor may have
good reason for low or no diversification. Most commonly this will be when
an investor has a high conviction of which way specific assets or markets are
going to perform and wants to exploit this scenario.
This will mean they have much lower diversification and could make large
gains if proven right; or suffer large falls if proven incorrect. Understanding
your Diversification Benefit is important to ensure you don’t receive any
unwelcome surprises..
Protection against adverse markets
Investors will typically look to maximise diversification as a form of
insurance when they are unsure as to which direction markets are going to
move. Essentially, they want to spread their risk to avoid large drawdown
events.
It would be useful to keep in mind that a portfolio where everything is going
up at the same time, can also turn into a portfolio where everything goes
down at the same time. That’s not diversification!
Let us help
If close to retirement or sitting on large unrealised gains you would like
to protect, then it may pay to better understand what your Diversification
Benefit is. We can provide you with a free report using FE Analytics
software which will tell you both the amount of risk you are taking and the
Diversification Benefit gained. We can also use this report to check whether
your funds are performing well, or not - when compared to other equivalent
risk rated investments or portfolios. Furthermore, we can identify if you are
paying too much in charges - which will also impact any benefits you are
receiving!
If you would like to receive your free portfolio report or would find it
helpful to have an initial conversation, then please call our office or visit
our website for further details. You can also email me at:
[email protected]