Oran Hall | Choosing a diversification strategy that pays off
Diversification is readily advanced as a risk-management tool in investment management. It is more than just not ‘putting all your eggs into one basket’ and should not be applied in a random way.
A portfolio can be diversified in several ways: by type of security, currency, market, management, term (long or short), type of income generated, industry, and quality of the instrument – particularly in the case of bonds.
Some investors opt to invest in pooled investment funds including unit trusts, mutual funds, and exchange-traded funds as one way to achieve diversification. There are many types of those funds, and they invest in many different types and combinations of securities.
Investors may opt to invest in only one type of fund or in a combination of funds and feel comfortable that they have diversified their investments well.
This is not necessarily true. Investing in one type of fund – an equity fund, for example – does present some form of diversification as the investments may be spread across companies in several industries and even several currencies and markets. But this approach rests solely on one type of security. Effective diversification would require investing in other types of securities.
If we keep our focus on equity funds for the time being, it is quite likely that a fund may not be well-diversified because its investments are skewed to a few stocks although there could be several stocks in the portfolio. Much depends on the investment policy and philosophy that guide the management of the fund.
One approach that may be used to correct this situation is to invest in several different types of funds – bond funds and equity funds, for example. Blended funds, also called mixed funds, may also be employed as they generally invest in a wider range of asset classes. But this is not true of all of them.
The downside to using pooled funds like mutual funds and unit trusts for the purpose of diversification is that they are not customised funds. Every investor in a fund has the same asset mix.
When an investor chooses to invest in more than one pooled fund, sometimes to benefit from the varying skills of different fund managers, there is a real danger of overlap – a case in which the investor invests in the same security more than once, due, in this case, to the funds investing in the same security. In many cases, investors do not know the securities in which the funds invest.
The benefits of diversification may be lost or reduced in another situation – when there is more than one person managing different portions of an investor’s portfolio. The fund managers tend not to know that the investor has other investments and are thus not able to decide on a suitable asset mix giving due consideration to the investor’s full portfolio. This also exposes the portfolio to the risk of overlap and reduces the level of diversification.
To avoid this situation, each manager should know what the client’s full portfolio looks like, but this may change from time to time and make the management of the portfolio untidy. In such a situation, the investor’s overall asset mix may not be consistent with the investor’s profile, goals, risk tolerance, and investment objectives.
Considering that some investors personally manage some of their funds in addition to what they put into managed funds, there is a further risk that the full portfolio may not be effectively diversified because due regard is not paid to the composition of the full portfolio – the sum of all elements of the portfolio under different management arrangements.
If the goal of the investor is to maintain an asset mix within a specified range, multiple arrangements can make it very difficult to maintain that mix and to maintain effective diversification of the full portfolio.
Even where the above issues are not present, attempts at diversification can be ineffective if too little of the resources are invested in some instruments and if the funds are spread across too many asset classes and too many securities as this may not allow sufficiently for the good performance of some investment vehicles to impact portfolio performance meaningfully.
Portfolio diversification should not be seen in isolation from the many other factors that generally determine the success of an investment programme. These considerations include the investor’s risk tolerance, the time horizon, financial resources, and personal and financial circumstances.
Considering the different needs, circumstances, and profiles of each investor, it can be said that each is unique. The eggs put into the basket, into which part of the basket they are put, and in what proportion should reflect the foregoing and the general environment in which the basket is situated.
- Oran A. Hall, the principal author of ‘ The Handbook of Personal Financial Planning’, offers personal financial planning advice and counsel. firstname.lastname@example.org