Diversification, the only free lunch in investing

In recent weeks, the chances are your portfolio has lost value in a relatively quick period of time. Perhaps you are questioning your tolerance to risk. At Nutmeg, unless there is a significant change in your goals or horizon, we recommend sticking to your financial plan. In general, we also recommend investing for a minimum of three years. As we have seen, markets can drop at any point, so you need to give your portfolio enough time to ride out the storm.

Here’s where diversification comes in. There is a good reason why diversification is called “the only free lunch in investing”¹. It has the ability to significantly reduce the risk of your portfolio, without compromising expected return. That is why, at Nutmeg, diversification is one of our core principles of investing.

A free lunch needs a big basket

The benefits of diversification have been widely recorded over time. The concept is simple: if you want to invest in the stock market, then spread your risk across multiple companies, thus reducing your exposure to the risk of any single one of them providing disappointing returns.

Let’s look at some numbers. From 31 December 2019 until 29 March 2020, the S&P 500 index lost approximately 29% of its value. While this is a dramatic loss, approximately 20% of the index constituents lost more than 50% of their value, while about 40% of all constituents lost less than 30%. In other words, the losses were not spread evenly².

This is true in general: the returns of individual companies vary significantly and holding a basket of them can diversify your risk. This concept applies across industries, asset classes and countries.

The risks of a concentrated bet

The example below helps to show the dangers of being insufficiently diversified. It shows performance of equity indices since 2003. The blue line is the MSCI USA Index, which is a portfolio of large, mid and small-cap US equity securities across all sectors. The red line is the MSCI USA Energy Index, a portfolio of companies in the energy sector.

Both indices are considered risky equity investments and, over the long run, yield fairly similar returns. But they have followed a different path to get there. The Energy Index provided stellar performance between 2003 and the Global Financial Crisis of 2008, which may have convinced an investor that the energy sector was a better investment strategy than a broadly diversified one. The ten years after that were, again, a period of sharp outperformance. But look what happens in 2014 and onwards. The Energy Index suffered much bigger losses than the broader index.

Judging by the ups and downs, the energy sector is the riskier investment, while the broader index offers a smoother investment path. This example illustrates that a portfolio that is not well diversified may end up being a concentrated bet, which may be more risky than holding the broader index.

The “free lunch” still applies with low-risk investments

The benefits of diversification do not only apply to stock markets but can also be observed with lower risk investments, such as bonds. The chart below shows performance of two similar bond indices since 2005. The blue line is the Bloomberg Barclays US Government Index which contains US government bonds. The red line is the performance of the Bloomberg Barclays Global Aggregate Index (hedged to US dollar to avoid any currency impact), which contains investment grade bonds of 24 countries.

They are both considered safe investments and over the long-run yield similar returns. However, it is clear that the globally diversified index provides the smoother investment path.

Staying the course

This principle of diversification is important to remember in times like these. Moving your investment into a safer asset, such as government bonds or cash, might seem like the best option right now, but consider whether in doing so you are limiting what your money can do for you. When it comes to less risky securities, you should be just as diligent about the composition of your portfolio. A portfolio of low-risk securities may not be well diversified, which means you might miss out on the free lunch when you most need it.

This will be especially true during a subsequent recovery. And if history teaches us one thing, it is that a recovery is eventually coming.

Sources

1. The phrase was first coined in 1952 by Harry Markowitz, widely considered the father of modern portfolio theory.
2. Data from FactSet.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.