20 July 2017

Diversification — more than just a free lunch

You don’t hear market pundits waxing lyrical about the benefits of diversification. The ‘experts’ you read about in newspapers and investment magazines generally aren’t those sensibly putting their eggs in different baskets.

Instead we have an in-built bias towards ‘conviction’. We love to read stories of fund managers who saw something coming that no one else did. And we only usually hear about those who gambled and won rather than those who got it badly wrong. We seem to prefer reassuring lies rather than the inconvenient truth that all known information is already incorporated into security prices, and that market movements are, to all intents and purposes, random and unpredictable.

Diversification, by comparison, seems dull and boring. But it’s hard to overstate what a brilliant deal it actually is. It’s been described as the one free lunch for investors, but even that understates its importance. Diversification isn’t a one-off meal; it’s a buffet to sustain you every day of your investing lifetime.

When most people think about diversification, they think about reducing risk. It certainly reduces different types of risk, such as being overly exposed to one or a small number of individual securities and that of being invested in only one market.

Another advantage is that, because stocks and bonds are inversely correlated — in other words, one tends to go up in value as the other goes down — diversification also gives you a smoother ride towards your investment goals.

But a benefit of diversification that many people aren’t aware of is that it also delivers more reliable investment outcomes.

Wei Dai, Senior Researcher at Dimensional Fund Advisors, recently conducted a study entitled How Diversification Impacts the Reliability of Outcomes. In the resulting white paper, she explained how having a diversified portfolio is critical to capturing the premiums associated with different factors.

Of course, outperformance cannot be guaranteed, but academics have demonstrated how, for example, over the long term, small-cap stocks usually outperform large-cap stocks, value stocks beat growth stocks, and stocks with high operating profitability outperform those with low profitability.

But capturing those premiums is more complicated than it may first appear. Just because, say, small-caps rise by 10% across the board in a particular year, that doesn’t mean that every small-cap stock rises by the same amount. Indeed, some may produce stellar returns, while others perform very poorly. Predicting, at any one time, which small-cap stocks are going to outperform is extremely difficult. Missing out on the stocks that perform best will mean that you don’t receive the full benefit of the small-cap ‘premium’.

To make matters worse, choosing only a few small companies adds to concentration risk, and if, as so often happens, the original choices prove to be wrong, changing them can add significant cost as the difference between the buying price and selling price, known as the spread, of small companies can be extreme. This will further reduce your returns. The answer is to diversify broadly, to stay invested and to avoid trying to time the market.

Wei Dai then went on to ask, How do different levels of diversification impact on the probability of outperformance?

Quantifying probabilities in investing is not an exact science, but the Dimensional study looked at the chances of a range of simulated US large-cap portfolios, with differing levels of diversification, outperforming the Russell 1000 Index, over different time periods. It calculated that a fund with 50 stocks in it had a 69% chance of outperforming the index over 10 years. The figure rose to 92% for a fund containing 500 stocks. But the Dimensional Adjusted Large Cap Equity Index, which includes the full large-cap universe of 1,000 names, had a 96% chance of outperforming the Russell 1000 Index over 10 years. In other words, the more diversified the portfolio, the greater the chance of outperformance, especially over longer time periods.

Another advantage of diversification, the study found, is that the difference between the return from the asset classes being targeted and that of your portfolio, steadily decreases as portfolios become more broadly diversified. Again, this enables the investor to capture the premiums they’re targeting in a more reliable way.

The beauty of broadly passive funds — whether traditional, market-cap weighted index funds or factor-based funds such as those offered by Dimensional — is that they have diversification built in. To use Jack Bogle’s famous analogy, instead of looking for a needle, you’re buying the whole haystack.

Actively-managed funds, by definition, are less diversified. According to the CRSP US Mutual Fund Database, as of December 2015, more than half of large-cap equity funds contained fewer than 90 stocks. Of course, it’s possible for an active manager to identify enough of the future outperformers and discard enough of the losers to beat the index. But the overwhelmingly likelihood is that, after costs, over the long term, the fund you choose will underperform the market.

Diversification really does make sense, and more importantly it significantly improves the performance of your portfolio. Remember, it’s not a free lunch, it’s a free lifetime buffet.

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