Is diversification really the only free lunch in investing?

While diversification is often termed ‘the only free lunch in investing’ I am not necessarily a believer. Diversification for diversification sake can mean investors invest in substandard assets that drag portfolio returns lower. We do subscribe to the view that sensible diversification that pays homage to the 80/20 rule (80% of the value from diversification can be achieved by implementing 20% of the possible diversification strategies) can add significant intrinsic value particularly when interwoven into ones asset allocation and asset selection process and, therefore, is a worthwhile pursuit.

How much and by what means diversification is achieved depends on an investor’s goals and highlights the value of good quality advice via an accredited financial advisor, broker or planner. While we have shown the table below since 2016, we cannot emphasise enough observing the asset allocations of some of the most sophisticated investors, such as the Future Fund can assist as a yardstick for investors to assess their own portfolio.

When to diversify

Since establishing the firm 8 years ago, we have spoken with hundreds of investors who, broadly, believe their portfolios require greater diversification. Many confess an overweight position in property and Australian shares, with the former being difficult and expensive to rebalance and, therefore, the latter being of primary interest. So, do investors diversify and if not, why not?

 

Everyone loves a stock story, with Australia home to many great emerging and emerged companies. On a spectrum, we can broadly think about them from being relatively stable, typically more mature companies that pay strong dividends (so called blue chip) to the more speculative which are targeting growth over profits without a dividend. In conversations with investors who hold an overweight position in these blue chips, we commonly find that while they equally recognise the need for diversification within their portfolio, they feel familiar with these stocks being household names that they have held for many years. Therefore, the thought of selling these shares to move into another asset class to achieve greater diversification is perceived as taking greater risk as it’s a move from the familiar to often something less familiar even though, rationally, the move is designed to lower portfolio risk.

If we consider the other end of the spectrum, the more emerging pre-profit companies have recently been heavily sold off and, in some cases, trading at a fraction of their prior highs. While their current valuation may be supported by the changes to fundamentals (high cash rate and therefore discount rate, in part justifying the lower price), we commonly hear that ‘we think it’s at its lows’ and therefore do not want to sell. In this regard, the fear of missing out on the upside dominates decision-making rather than an unbiased observation of the outlook.

So, when do investors typically diversify? In our experience, when we are in an equity market environment similar to what we are today, characterised by a broadly softening index and overall share prices. We have found that in these times, the rational thought process doesn’t play second fiddle to the fallacy of familiarity nor fear of missing out.

It is unrealistic to believe investor psychology, including fear of missing out or the fallacy of familiarity, does not influence investment decisions. Being aware of such biases and balancing them appropriately alongside objective investor rationale will enhance one’s investment credentials and likely portfolio outcomes.

A deep dive on credit as a diversifier

While we can’t speak to the other asset classes that the Future Fund invests in including Infrastructure, Timberland and broad Alternatives, we can provide a perspective on why more Australians are investing in Credit which in the Future Fund portfolio, occupies a larger share of the portfolio than both Australian Shares and Property, in stark contrast to many other investor portfolios. As outlined above, some are increasing their allocation due to overweight positions in other assets class. Another driver observed is the demographic shift with the so called baby boomers, who in general, are moving from a wealth accumulation to a wealth preservation mindset and thus, are drawn to fixed income/credit investments that prioritise capital preservation, are less influenced by the risk on/risk off cycles of equity markets and can deliver a ‘real’ rate of return, in particular shorter duration strategies where returns typically lift alongside inflation and higher global cash rates. This move towards fixed income and credit has seen an influx in new managers and investment opportunities in this space, we remind investors not all managers are of the same pedigree and for an asset class designed to preserve capital, investing with those that have a track record and the right incentives remains paramount.