David Stevenson: Diversification made easy

A few months back, I had the good fortune to sit in on a customer panel session at a leading stockbroking firm. My primary purpose was to quiz the poor unfortunate clients on their behavioural vices for an up and coming book – I wanted the truth about their over-trading, and their overconfidence in their ability to pick shares in the style of Warren Buffett.

But what I actually got was a bunch of fairly level-headed folk who were largely terrified of making mistakes and who looked to people like me (sadly) to provide them with clues. More to the point, when I started talking about diversification they all – to a man and woman – said, to paraphrase one very charming lady: “How much is enough? We all understand that you have to diversify but how exactly should you do it?”

It was a cracking question to which there’s a proper answer – and a real answer.

The proper answer is to listen to the collective wisdom of generations of investment academics and use modern portfolio theory, as devised by professor Harry Markowitz. This suggests that you look at risks and returns, alongside volatility, and then compute something called “an efficient frontier” of different assets, allocated sensibly, in an optimised fashion. It’s what the big wealth managers claim to do (although they actually don’t in most cases). It’s also what many fine and upstanding financial planners will do a very fair fee.

Unfortunately, its not what anyone I’ve ever talked to actually does. It’s not the real answer. Here’s Professor Markowitz at a conference in Chicago on what he invested in: “I should have computed co-variances of the asset classes and drawn an efficient frontier – instead I split my contributions 50/50 between bonds and equities”. Just to ram the point home, its also worth quoting

He’s not alone. Take the father of modern risk analysis in economics, Bill Sharpe, on the subject of how he builds his portfolio: “I invest in various funds, large stocks, small stocks and international stocks”. Or Eugene Fama, the father of the index funds movement – when asked by a publication called Investment News what he invested in, he replied by detailing a fund invested in the broad-based US Wilshire 5000 index, plus small cap and international index funds, and a just over a third in value-oriented stock indexes and short-term bond funds.

The vast majority of UK-based academics that I talk to also maintain a very sensible 60/40 split between equities and bonds, with just a couple of funds of each. The odd few go a little further, adding a few additional asset categories and maybe getting up to 6 funds – but that’s it.

Over in the US, the idea of a simple, small number of funds has been taken to an extreme degree by one commentator: Paul Farrell. He recommends so-called “lazy” portfolios with between just 2 and maybe 8 funds. This lazy portfolio proposition is built on four simple principles:

1. Use funds to capture the market, not individual shares

2. Use index tracking funds to track the market efficiently and cheaply

3. Keep portfolios simple with no more than ten individual funds

4. Buy and hold – don’t over trade, just stick with the portfolio for the very long term.

Some enthusiasts for this approach maintain that just two funds could do it: 60 per cent in an equity index fund (tracking, say, the FTSE All Share) and 40 per cent in a bond fund (tracking the FTSE All Stock Gilts index). Just these two funds could give you all the diversification you need!

But I suspect that most of us would want a little but more spice than that. James Norton of UK financial planning firm Evolve of UK financial planning firm Evolve has studied returns between 1988 and 2008 to work out just how many funds you probably need. He started with a classic 60/40 split (Citi Bond index and FTSE all Share) which produced an average annualised return of 8.83 per cent a year with volatility (standard deviation) of 9.58 per cent. He then progressively added funds until he got to eight (FTSE All Share, MSCI World index exc UK, emerging markets, value and small cap for both the UK and the World), which produced a higher annual return – 9.91 per cent – but with almost exactly the same volatility: 9.69 per cent.

Norton’s conclusions are backed up by a separate study from American commentators Paul Merriman and Richard Buck, who ran a similar analysis back in September 2005. They ended up with a nine-way split and similar results.

So, between 4 and 9 asset classes or funds should just about do it. However, there are still analysts who think you need fewer. One of them is US analyst Rob Arnott who says: “Most of the advantage of diversifying happens with three or four significant positions in seriously cheap assets. If you go beyond ten, you’re deluding the opportunity set. You’re reducing your ability to add value.“ You can listen to my interview with him below.



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Tim Bond at BarCap also cautions against over-diversification, favouring a focus on China’s infrastructure boom and the new carbon lite economy. “Under those circumstances, diversification, is literally the worse possible solution to your investment needs… it’s the worst possible thing to do. Actually, you need a really narrowly focused portfolio, where you’re investing specifically on that theme”. You can listen to him explaining this theme below.



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Putting his money where his mouth is, Bond is running his own highly focused fund, called RADAR, with just seven individual positions.

adventurous@ft.com

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