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Why is diversification so important?

GT Advanced Technologies was a sure thing.

It was supposed to be the primary supplier of sapphire glass to Apple, which was going to be used on the new iPhone 6 and iPhone 6 Plus. It had hundreds of millions of cash in the bank at the last quarterly filing, a strong history of earnings growth, and a lucrative opportunity with Apple. The market was so confident in the stock’s potential, that many investors started borrowing money to invest more.

Only, it wasn’t a sure thing.

GT Advanced Technologies (GTAT) failed to deliver the glass on time. The company had no minimum purchase commitments from Apple, and no exclusivity contract. They also had a nine-figure loan from their main customer, Apple, to cover their day-to-day operations, which was essentially repayable on demand. And demand repayment they did.

The company swiftly filed for bankruptcy and the stock lost almost all its value overnight.

Many regular DIY investors were lured in by the company’s story and the idea of getting rich quick. Their excitement and subsequent heartbreak was chronicled on a now-defunct stockpicking forum called ‘thecontrarianinvestor.com’. Luckily, a few of their comments have lived on, and are reproduced below:

Diversification story 1

Diversification story 2

Diversification story 3

Diversification story 4

You can’t help but feel sorry for these people. Nobody should have to sell their house or lose all their retirement savings because of the performance of one single stock. And although not putting all your eggs in one basket is basic investing theory, none of us are immune to the power of a good story and the allure of getting-rich-quick.

It’s an extreme example, but if there’s one thing that can be learned from the collapse of GTAT, it’s that no matter how much of a sure thing your favourite stock is, you should always, always, always diversify.

Diversification and the volatility tax

 

Diversification’s importance stems from a simple, but surprisingly little-known, law of investing: losses are worse than equivalent gains are good. A 10% loss is disproportionately worse than a 10% gain, because when a portfolio falls 10%, you then need an 11% gain (not 10%) to break even. For example, if your portfolio goes down 10% then goes up 10%, you’ve still lost money (£100 -> £90 -> £99). Taken to the extreme, if you lose 50% on an investment, you then need to gain 100% to break even.

In jargon terms, this is often called the ‘volatility tax’. The idea is that the more volatile a portfolio is, the more often it’ll incur losses. Because these losses have a bigger impact than gains, the portfolio must generate higher and higher returns just to break even. Volatility can be thought of as a tax on a portfolio, because of the asymmetry between investment losses versus gains.

Diversification and the volatility tax

An un-diversified portfolio increases the chance that you’re exposed to a single investment which incurs heavy losses. By diversifying, you’re reducing the impact that a single bad investment has on your portfolio, and so reduces the impact of the disproportionately harmful losses that could inflict on your portfolio.

Reducing risk

 

As we all know by now, compounding is the most important asset that any investor has on his side.  But as we’ve seen from the GTAT debacle, large losses can undo decades worth of compounded growth. Diversification helps minimise the effect of any GTAT’s in your portfolio, and ensures that you’re able to continue to compound over the long term. It reduces your portfolio’s risk.

A properly diversified portfolio will never generate 80% returns in any one year, but it will never lose 80% in a year either.

To show how beneficial diversification can be at reducing risk, the chart below shows the risk/return characteristics of all the sectors in the S&P 500 since 1989. For example, the technology sector had 24% volatility with 12% return, and the telecoms sector had just over 18% risk, and just under 6% returns:

Sector diversification in the S&P 500

Source: Morningstar, monthly returns from 1989 – 2019 

What’s interesting is that by investing in all the sectors together – i.e. by buying the whole S&P 500 – your returns would’ve been better than the average sector’s return (the average sector returned 9%), but with not only far less risk than the average sector’s risk (which was 18%), but also with lower risk than all sectors bar one (consumer staples).

Given the disproportionate effect that losses have on long-term returns, diversification’s ability to reduce portfolio volatility reduces the magnitude of your losses, so minimises the volatility tax.

If you’re able to reduce taxes through something as simple as buying more things, why wouldn’t you?

Staying the course

 

Another major benefit of diversification’s ability to reduce volatility is that it helps us stay invested.

Everyone says they’re willing to withstand a 30% drop in portfolio value when they’re filling in the risk-tolerance questionnaires. And maybe they can, on a spreadsheet. Maybe they’ve done the maths and figured out that they can still pay their bills and maintain their emergency fund with a 30% drop in their portfolio. But what about mentally? A 30% drop can be devastating to an investor’s willpower – it triggers questions like “What if my portfolio keeps falling?”, “What if I’ve hired the wrong investment manager?”, “What if my investment philosophy is wrong?”.

All these questions increase the likelihood that you’ll capitulate, and pull your cash out of the market.

Staying invested during large drawdowns is incredibly difficult to do – for anyone. And that’s where diversification comes in. It helps reduce the impact of drawdowns that could have been avoided by investing too heavily in one area. It helps avoid those difficult questions, by smoothing out long term returns, and reducing the temptation to pull the plug on your investments – helping you benefit from compounding.  

Researchers from Morningstar put some number to it, and tested whether higher risk-adjusted returns helped investors stay invested. i.e. they tested whether riskier funds caused investors to pull their money out, and miss out on future performance. For reference, a fund’s “timing gap” is the difference between the return of an investment staying in a fund for an entire period, versus the return actually achieved by investors into the fund. A timing gap might exist when investors miss out on performance by withdrawing cash from the fund at the wrong time.

Morningstar found that “higher risk-adjusted performers have narrower “timing gaps,” on average, than lower performers, which have wider gaps.” This means that riskier funds cause investors to behave badly. Investors reduce their returns by withdrawing cash at the wrong times. And that’s exactly why it pays to be diversified – it minimises the temptation to make behavioural mistakes like tampering with your portfolio and damaging your returns by doing so.

This is the same quilt from my previous post. How much easier would it have been to stick to the portfolio represented by the grey boxes, than by investing in any other colour?

Diversification quilt chart

Source: JP Morgan’s ‘Guide to the Markets’

It’s the same message as with the sector diversification chart. You still get excellent long-term returns, but with much less risk than by investing in the majority of individual asset classes.

There’s an old saying in finance that your portfolio is like a bar of soap – the more you touch it, the smaller it gets.

Diversification helps you keep your hands off.

Conclusion

 
    • The volatility tax is the idea that investment losses are worse than the equivalent gains are good. A 10% loss is worse than a 10% gain is good.
     
    • Diversification reduces the volatility tax, by reducing the impact that a single bad investment has on your portfolio.
     
    • Diversification reduces a portfolio’s risk, whilst still allowing the portfolio to generate high returns.
     
    • This risk reduction helps investors stay invested and benefit from long-term compounding.

The next post in the series looks at the UK’s domestic market, and examines whether or not it’s sufficiently diversified to be held as a portfolio. 

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Past performance does not guarantee future performance and the value of investments can fall as well as rise. The information on this site is provided for information only and does not constitute, and should not be construed as, investment advice or a recommendation to buy, sell, or otherwise transact in any investment including any products or services or an invitation, offer or solicitation to engage in any investment activity. Please refer to the full disclaimer on the disclaimer page.

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