Investor Essentials: What is diversification?

nutmegonomics


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In 1952Nobel Prize laureate Harry Markowitz famously said “diversification is the only free lunch in investing.” This is potentially confusing, as nothing in investing is exactly free and even with the most perfectly constructed portfolio, you’re not getting fed.

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What Harry was getting at though is crucial for any investor to understand, and central to Nutmeg’s investment approach.

As a concept diversification is simple: if you want to invest in the stock market, then spread your risk across multiple asset classes, sectors and companies, thus reducing your exposure to any single one of them providing disappointing returns. The idea is that diversification reduces the risk in your portfolio, without compromising expected return. That is why, at Nutmeg, diversification is one of our core principles of investing.

Diversification is achieved through asset allocation, which means simply the mix of investments held in a portfolio, and at Nutmeg the way we deliver this is through our strategic allocation framework. To create the framework, we use over 25 years of historical data to examine the contributions of each individual asset class to overall portfolio efficiency and eliminate asset classes with no incremental value on a risk-adjusted basis. Our focus is global diversification. We offer exposure to large, mid and small cap stock markets across global developed and emerging markets, and a broad range of fixed income asset classes, such as government and corporate bonds.

Of course, these allocations will then be aligned to your own appetite for risk, expressed in the risk level you will have chosen for each of your Nutmeg pots. To manage this, we use internally and externally defined benchmarks and equivalent risk portfolios to benchmark our performance and risk. Using our strategic asset allocation as a framework, we look to gain a comprehensive understanding of portfolio positioning by reviewing both top-down risk factors (Geography, Style, Factor) and bottom-up risk factors (each single position in isolation).

Below you can see the diversification breakdown of the different asset classes in our fully managed risk level three and fully managed risk level eight portfolios (you can explore the diversification breakdown in the ‘Past Performance and asset allocation’ section of our fully managed portfolio page on the asset allocation tab):

Risk level 3:

bar chart showing asset breakdown

Risk level 8:

Bar graphs showing asset breakdown

Is diversification really the only path to investment success?

What is the alternative to diversification? You could go for a more concentrated portfolio approach by investing, for example, with a brand-name fund manager and stock picker. However, your portfolio is often going to be limited to one market so you might need to select more than one to spread the risk among different markets. Furthermore ail to outperform their benchmark over the long run, or they may even underperform quite dramatically (some investors had highly concentrated exposure to Neil Woodford funds for example, and suffered as a consequence). An even more concentrated allocation approach would be to pick single stocks and while the rewards can be exceptional (imagine if you had invested with Apple in early 2000), there are many more failures for stock-pickers than successes. We covered the Gamestop saga in a  where some investors made quick profits but other late joiners had deep losses.

Beyond diversification

Providing you with a diversified portfolio is not the end of the expert investment management our clients receive. For our fully managed, socially responsible and Smart Alpha portfolios powered by J.P. Morgan Asset Management, the strategic asset allocation is a starting framework, after which the investment team regularly makes strategic adjustments to manage risk and seek higher long-term returns. To do this, they incorporate a variety of inputs. These include:

  • Cyclical macroeconomic and geopolitical policy analysis;
  • Thematic research to identify structural trends;
  • Asset valuation and price dynamics, including factor analysis and market positioning;
  • Regime and behavioural analysis to understand our stage of the economic cycle; and
  • Behaviour of markets relative to history and empirical studies.

In essence, our investment team uses a tried and tested investment strategy with diversification at its core, combined with industry-leading systems to provide comprehensive historical risk reporting, and forward-looking portfolio analytics. All this allows our clients to get the best out of their investments, with the confidence of knowing they have experts helping them towards their financial goals.

 

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.

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