The Dangers of Diversification
Diversification is important. Because we can never be 100% sure an investment will work out, it is prudent to spread our bets. Investors are often told that part of thoughtful portfolio construction is proper diversification between asset classes and within asset classes. While we generally agree with this sentiment (there is a lot of nuance here, but that’s beyond the scope of the article) one of the biggest dangers we see of investors diversifying is that it gives them a false sense of security which can cause them to let their guard down when it comes to individual asset selection. Put it another way, investors sometimes don’t do the work to properly understand the assets they hold because they feel diversification will protect them if things go bad. Below are 2 case studies that we’ve seen in real life that shows how this over-reliance on diversification can lead to trouble.
Not all bonds are created equal
Sometimes we see clients with large bond portfolios and when we ask them why they hold that many individual bonds we are often told a familiar tale: “Since the return tends to be the same it’s important to diversify the credit risk.” In principle this makes sense – why concentrate risk on any given bond when the returns will roughly be the same (assuming you bought at par, eventually the bond will mature and your return will be the coupon you received). However, this strategy can lead to thoughtless diversification which can be a drag on returns. For example, let’s say you had a $10million portfolio which about 50 bonds (so $200,000 each) yielding 5% on average. Now let’s say you at random selected those 50 bonds to diversify the credit risk, and only one of those bonds defaulted. Doesn’t seem that bad, 50 invested, 49 returned money, so whats the issue? The issue is that the $200,000[1] lost due to default now has to be made up for by the rest of your portfolio, dragging down returns. In a scenario without default you were expecting $500K in returns (5% of $10million), however because of the default, $4million of your $10million of capital now exists solely to replace the $200,000 lost in the default (5% of $4million is $200K), thus giving you only $300k in returns. Put it another way, 40% of your capital is now being used just to make up a loss, rather than bringing you incremental gains. Because returns on a bond are limited, the very nature of a bond that makes them reliable can work against you when things go wrong.
Often a client’s response to this is that they only invest in Investment Grade bonds and thus they should be fine. But anyone who went through the Global Financial Crisis knows how credit ratings can let down investors. In fact, even data pre-crisis showed that the cumulative probability of distress of a BBB bond over a 5-year period was 6.44%[2]. This implies that even if you have a large number of investment grade bonds, doesn’t mean you’re in the clear.
What this indicates is that blind diversification can be quite risky. Thus it’s very important to do your homework on each and every asset you put into your portfolio, especially when the general consensus is that the asset is ‘safe’.
Too many stocks spoil the soup
We recently had a client come to us with a portfolio of 58 stocks. These stocks position were of roughly the same value, had global businesses, and were across industries – talk about diversified! However upon a quick inspection of the portfolio, we noticed that the bottom 10 stocks on average were losing 45% this year. Quick math showed us that the top 48 stocks would have to on average have a return of 40% this year for the portfolio to match the year-to-date return of the relevant benchmark this year! Obviously this is very hard to achieve. If we ever found someone who can accurately name 48 stocks that will return 40% each in a given year we would give them most of our money.
So what went wrong? In the name of diversification the client had perhaps not been as diligent as they should have on the assets in their portfolio. Thus the laggards really dragged down their returns, even though a good portion of the portfolio had outperformed the index. Bad investments, even when small in number, can really hurt, and diversification won’t give you much protection.
(And yes if you’re wondering, when we did the full analysis, the portfolio was underperforming the benchmark by a significant margin).
In Conclusion
Diversification in a general, is a good idea. But do ensure you don’t use it as a crutch to not do your homework. Deep losses, even in just a few positions can be a serious drag on your portfolio. Know what’s in your portfolio, and why it’s there, and how it’s doing.
Happy investing!