Evidence-Based Investing: Part Three: Investment Portfolios Should Be Diversified

The core principle of an evidence-based approach is that risk and return are related. The remaining principles of the evidence based approach flow from this core principle. In the second installment in our series on Evidence-Based Investing we presented some of the evidence which demonstrates that a buy and hold “passive” investment strategy will outperform an “active” investment strategy that tries to beat the market by picking superior securities or to time the market’s ups and downs.  In this third installment we focus on diversification.

Diversification helps to reduce risk. In the extreme, if you were to invest only in one stock, you would have exposure to a lot of risks. To begin with, all stocks have a certain amount of exposure to the general economic environment. For example, if global growth slows, expectations for future economic growth tend to get more pessimistic. Investors lower their forecasts for demand for goods and services which trickles down to the expected sales of goods and services for individual industries and companies. All companies share this risk. But individual companies have all sorts of other company specific risks. What if the very well respected CEO of a company suddenly leaves? What if the company suddenly faces a massive lawsuit because its main product harms someone? What if the company’s main distribution centre catches fire and cripples the operations for nine months? What if it is discovered that a company has been filing fraudulent accounting statements? Investing in only one company’s stock exposes the investor to the downside risk of all of these one-off company specific types of risk.

Spreading your investment across a large number of companies mitigates the impact of company specific risk. In fact something that is bad for one company in your portfolio might even be good for another company in your portfolio. To put it another way, when the share prices of some companies zig, others zag, and vice versa. A diversified portfolio of investments can therefore provide a much smoother return profile than that of an individual investment because the zigs cancel out the zags. Two stocks might have the same overall expected return but by combining them in a portfolio you reduce the volatility of the returns, or reduce the risk. Because investors are able to diversify away company specific risk by combining stocks in portfolios, the stock market actually doesn’t compensate investors for taking company specific risk. The expected stock market returns and risk profile embedded in current stock prices assumes that investors will diversify away all company specific risk.

The illustrative chart below from Dimensional Fund Advisors (DFA) shows how combining investments (securities) in a diversified portfolio adds stability to the overall return profile. When security returns have different patterns, it is possible that poor performance by one security is offset by good performance of another security. In fact, whenever there is anything other than perfect correlation, there can be benefits to diversification.

Combining securities in a diversified portfolio adds stability to the overall return profile

Holding a diversified portfolio of many securities is a good starting point but many Canadians, while diversified well in Canada, are not taking advantage of the benefits that can be gained by diversifying globally. The chart below (from DFA) shows the performance of the S&P/TSX Composite between 1991 and 2013. By diversifying the holdings and also holding stocks from outside of Canada you can see that not only is the annualized return higher, but the risk (standard deviation) is actually lower than if only Canadian stocks were held.

Performance of the S&P/TSX Composite between 1991 and 2013
Portfolios are for illustrative purposes only. Diversification neither ensures a profit nor guarantees against loss in a declining market.

Furthermore, it’s important to diversify globally at all times because it is difficult to forecast which markets are going to outperform in any given year. The colourful diagram below (from DFA) illustrates this point. What performs well in one year might perform poorly the next year. Timing the markets is just too difficult. To capture those times when a particular market is performing well it is important to diversify across all markets at all times.

It’s important to diversify globally at all times.Please visit again for the next installment of Evidence Based Investing where we will discuss the next principle: Asset Allocation Should Be Based On Risk Tolerance And Disciplined Rebalancing.