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DIVERSIFICATION BENEFIT - THE ONLY FREE LUNCH IN FRANCE
by Sam Hulson of First Equitable
Are you benefiting from diversification ? 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 .
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 . The events of the last 12 months have provided a stark reminder of this , and the fact is that well diversified portfolios should still have performed very well . However , making a judgement based only on positive or negative performance alone often doesn ’ t tell the full story . A point of comparison is also required using analysis based on other investments with the level of risk you are taking ; and that is where we can help …
Let us help If you have any existing investments and / or pensions , 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 : sam . hulson @ first-equitable . com
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