What is diversification and why do I need it?

Reasons for why we need to diversify can be found in the most unlikely of places. The Battle of Stalingrad, with an anecdote courtesy of Morgan Housel, provides an excellent example.

In late 1942, during the Battle of Stalingrad, a German tank unit sat in reserve on grasslands outside the city. These tanks were desperately needed on the front lines, but when operators attempted to drive them to where they were needed, something happened that surprised everyone – almost none of them worked. Out of 104 tanks in the unit, fewer than 20 were operable.

The problem? Mice.

Historian William Craig writes in his book ‘Enemy at the Gates’, “During the weeks of inactivity behind the front lines, field mice had nested inside the vehicles and eaten away insulation covering the electrical systems.”

The Germans had some of the finest engineering minds in the world, almost unlimited resources, and had created some of the most sophisticated machines in the world. Yet there they were, defeated by mice.

This situation had almost certainly never crossed their minds. What sort of engineer thinks about mouse protection? It was completely unexpected, because this sort of thing had never happened before.

But that’s exactly the point. In the words of Stanford professor Scott Sagan, “Things that have never happened before happen all the time”.

Why do we need to diversify?

Most of the important events that shaped history had never happened before, until they did.

The great depression? Never happened before.

The Chernobyl disaster? Never happened before.

The Dot-com crash? Never happened before.

The Credit Crunch? Never happened before.

Brexit? Never happened before.

I could go on – the invention of the printing press, the industrial revolution, the discovery of penicillin, the advent of the internet – all were unprecedented events.

But that’s how we, as a civilisation, advance – one unexpected tail risk event at a time. It has always, and will always, be the case that a tiny number of hugely important events have the largest impact on the way the world operates.

Putting this into an investment context, we don’t know what’s going to happen in the future because most of the meaningful things that are due to happen have never happened before. This causes a problem for investors, because people can’t predict things that have never happened before.

It seems like common sense, but it’s worth thinking about, that the main events that affect the market – the ones that cause the huge crashes and huge booms – move the market specifically because they’re unexpected. If they were expected then they’d already be reflected in stock prices.

So how do we both ensure that our portfolio is robust against the unexpected and never-before-seen negative shocks that we’ll inevitably face during our investing lifetimes, whilst also benefitting from the drivers of growth that we can’t possibly predict? We diversify.

What is diversification?

It seems like a huge challenge to create a portfolio which can withstand the bombardment of unpredictable catastrophes, but can also benefit from the unpredictable tiny minority of events that drive the economy. But it all comes down to the simplest of things – umbrellas and ice creams.

Imagine a business that sells only 2 things – umbrellas and ice creams. Because the business owner doesn’t know what the weather will do, he sells both. When it’s sunny, umbrella sales will be low, but ice cream sales will be high, and vice versa. He’ll never go out of business, because one part of his business will always be doing well.

At its core, diversification is the idea of spreading your bets. It involves buying a broad mix of different investments, so that if one goes wrong, your overall portfolio doesn’t suffer too much because your other investments have done well.

Over the course of your investing career, some of your investments will perform poorly, others will perform well. Diversification is a way of coping with the fact that we don’t precisely know which investments will perform well at which points. Because we don’t know, we own lots of them.

When people talk about diversification, most people tend to think about diversifying by asset class. The classic example is owning both equities and bonds – the rationale being that because one asset class is risky and the other is not, as one performs poorly, the other should perform well. Other asset classes that are commonly held in portfolios include real estate, commodities, alternatives, and cash. All these asset classes help provide a buffer in case any of the other asset classes have a bad year. 

Because every post about diversification has an obligatory quilt chart in it, here’s mine:

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

Each of the squares represents one asset class, and they’re ranked by the asset class’ returns each year. The chart shows just how difficult it would be to pick the best performing asset class each year – even picking an asset class in the top half of best performers would be tough. You might get a couple of years right by pure luck, but picking the best performers consistently year-on-year clearly seems like an impossible task.

The grey squares, linked by the black line, show how a diversified portfolio of all the different asset classes would’ve fared. It’s never the best performer, but it’s never the worst either. In the right-most two columns, you can see that it’s provided about 6% a year returns, which is middle of the pack, but the volatility is very near the bottom of the pack. Simply owning all the asset classes gets you strong returns, low risk, and no need for a crystal ball.

As well as diversifying by asset class, there are several other ways to diversify your portfolio, which I’ll go through in future posts. You can also diversify by:

• Geography: owning assets listed in other countries
• Currency: not being too exposed to the fluctuations of any one currency (usually your home country’s)
• Sector: owning assets across all the different sectors (energy companies, technology companies, healthcare companies, etc)
• Securities: owning enough individual securities that any single security going to zero wouldn’t have too big of an impact on your portfolio
• Time: investing regularly enough that your returns aren’t overly dependent on any one time period

A strong portfolio is diversified across as many different planes as possible, safe in the knowledge that it has no single point of failure.

Conclusion

• Diversification is the technique of investing in a variety of asset classes/ geographies/ currencies/ sectors/ securities/ time periods to ensure that no single event can meaningfully damage your portfolio. It reduces your portfolio’s risk.
• We diversify because investors (including professional ones) can’t predict the future. Diversification protects us from events which we can’t foresee – helping us mitigate the ones that hurt our portfolio, and helping us profit from the ones that it can benefit from.

The next post in the series looks at exactly why diversification is so valuable for investors, and how its use can be beneficial for both portfolio performance and risk.