25 Jun 2019
Is diversification a good investment strategy?
Markets are cyclical and specific asset classes deliver variable returns at different times in that cycle in response to shifting macroeconomic factors. This makes having a undiversified investment strategy a risky proposition.
When it comes to delivering stable, inflation-beating returns over the long term, most investment professionals agree that diversification is the key to success. This is particularly true during periods of market volatility. We asked members of Investec Wealth & Investment’s Global Investment Strategy Group to share their opinion on diversification vs ‘di-worse-fication’.
“Diversification is truly the only free lunch in economics. It is, therefore, something that every investor should employ throughout their investment lifecycle,” explains Ryan Friedman, Multi-manager Investments Head at Investec Wealth & Investment.
To weather an economic or market storm, every prudent investment strategy must manage risk before considering returns. “That's because assets don’t move in the same direction in the same market environment. As such, to manage volatility or reduce the risk of a particular investment, investors must employ a diversification strategy.”
Is diversification for people who don't know where the sweet spot is?
Spread the risks
Diversification suggests investing in opportunities across asset classes, geographies, sectors, companies and themes. “This approach effectively spreads risk and offers greater opportunities, which creates balance and less volatility – what most investors aim for,” adds John Wyn-Evans, Head of Investment Strategy for Investec Wealth & Investment UK.
Prof Brian Kantor, Chief Strategist and Economist at Investec Wealth & Investment SA, elaborates that diversification mitigates the inherent risks associated with investing in single stocks or companies. “Avoiding isolated incidents, like what happened with Steinhoff or the fallout from BP's Deep Water Horizon incident, will help to preserve wealth.”
This is also an important concept for business owners or long-term (or life-time) employees to consider, adds Kantor. “Entrepreneurs and executives who own company stock, for example, automatically assume concentration risk. While this can deliver immense returns, and you don’t want to discourage this type of investment, it's also important to protect your wealth by constructing a well-diversified portfolio.”
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Too much of a good thing
The key to astute diversification, however, is to avoid a case of ‘di-worse-fication’, a term famously coined by Warren Buffet. “While a certain amount of diversification is appropriate, too much diversification can increase costs and complexity,” continues Friedman.
This concept is backed by research, affirms Annelise Peers, Chief Investment Officer, Investec Wealth & Investment, Switzerland.
“The study suggests that the diversification 'sweet spot' is roughly four different asset classes. This could also include diversification within a specific area, such as a spread of equities in different companies, or a spread of treasuries, gold and corporate debt for investors who aren't comfortable with bonds, as examples. Whichever diversification approach investors select, they must have clear conviction and shouldn't over-diversify.”
Chasing outsized returns
Those investors who want to chase higher returns can boost allocations within single asset classes or invest in fewer shares if they're confident about backing a winning company or sector. However, by diluting their diversification in this way, the risks increase commensurately.
“Investors must understand the trade-off between the risks and the potential returns, but the truth is that most people don’t understand the link between these two concepts. As such, from our perspective, diversification is not an inability to find the sweet spot. It’s about providing a product that is right for the majority of our clients who want to realise stable, market-related returns over the long term while protecting their wealth,” concludes Wyn-Evans.