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Diversification: The only free lunch?

The phrase that “diversification is the only free lunch in investing” is attributed to Nobel Prize winner Harry Markowitz, one of the grandfathers of modern portfolio theory. One of the cornerstones of investing is that there are no meaningful returns without risk. Investors who own volatile investments are compensated by a “risk premium,” which refers to excess return over risk-free assets, normally government bonds.

But while risk and reward do typically go hand in hand, smart diversification can help you either maximise your return for a given level of risk, or reduce your risk for a given return.

The “quilt” or “jellybean” chart below highlights the principle.

The chart shows the average returns from 12 different sectors in the UK investment fund market over each of the last 15 years.

You will note that:

The best asset class one year is rarely the best asset class the following year.

Asia Pacific and Global Emerging Market funds are the most volatile – often in the top or bottom two.

Cash is often one of the lowest-returning asset classes, except in times of stress e.g 2008 Credit Crunch.

There does not appear to be a predictable pattern to the returns.

However, the equally weighted portfolio (in white) is never in the top three or in the bottom four. It is less volatile, or risky, than any of the other asset classes.

And it is a really quite simple portfolio: as the name suggests, it is made up of 1/12th of each of the other asset classes, and rebalanced once a year.

This shows the power of diversification in reducing the volatility while still achieving a positive return.

The optimum portfolio?

So, as diversification seems to work, how can we apply it to individual portfolios?

Most investors want their money to grow at the best rate, but are only willing to take a certain amount of risk.

The risk may be specific due to our age, investment style and perhaps time until retirement and even during retirement.

If you could achieve the same return you desired but with less risk, that would be the ideal outcome. This is where the efficient frontier comes into play. The objective is to get our allocation to different asset classes as close to the efficient frontier line as possible.  This is why it is called efficient – it is the portfolio that is designed to achieve the best return for the level of risk the investor wants to take.

The efficient frontier was first introduced by Markowitz in 1952.  His continued research on portfolio theory won him the Nobel Prize in Economics in 1990.

The efficient frontier has a vertical and horizontal axis:

The vertical axis represents the expected return of the portfolio. The horizontal axis represents the risk, in the form of standard deviation (how volatile the portfolio is).

The efficient frontier line produces the highest expected return for any given level of risk. It is impossible to go above the line, and anything below the line is a sub-optimal portfolio.

A sub-optimal portfolio is one that provides less expected return for the same amount of risk or exposes you to more risk for the same expected return.

A core part of any financial / investment planning exercise is to establish the risk that an investor is willing or able to take. Then the optimal portfolio, or best mix of assets, can be determined.

Lower risk portfolios traditionally have more in bonds, with higher risk portfolios having more in equities – but always a diversified mix.

David Norman, Joint Founder and CEO, TCF Investment

Before jointly founding TCF Investment a decade ago, David (DAN) Norman held senior roles with life companies, banks and asset managers and was latterly CEO of Credit Suisse Asset Management (UK).

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