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Understanding what diversification is… and what it is not
Diversification is easily one of the most discussed topics in investments, but it is also one of the most misunderstood. If you think this statement is hyperbolic, consider two misconceptions that are often attributed to the failure of diversification.
The first, is when two asset prices move in the same direction over a given period.
The second is simply, when two asset prices move in the same direction, irrespective of the period.
Although this may sound like exactly the same thing, they are in fact two distinct elements of diversification that are often misunderstood. Reread any article that discusses the failures of diversification, and you may find one or both elements being misunderstood. Let us explore them in greater detail to understand where the failure occurs.
Understanding diversification
The most important thing to understand about diversification is that it is a continuum and not a binary phenomenon. What do I mean by this? Like most things in investments, you should think about them as continuums between two extremes and avoid the convenience of thinking about them in binary terms. At the one extreme, you have two assets that are perfectly correlated, either positively – they move together, up and down – or negatively, where they move in opposite directions. At the other extreme, they have zero correlation, or move completely independently of each other. This is where the first misunderstanding creeps in.
Most people struggle with the simple concept of two assets behaving independently, because they see them move in the same direction and assume that they must be correlated.
BUT what are the options for the behaviour of two uncorrelated assets?
If one moves up, what can the other do? If it moves up or down and you assume that it is then either positively or negatively correlated, what then does uncorrelated represent? There is no other option i.e., unless assets do not trade, they will invariably move up or down. The definition of uncorrelated is in fact that they will sometimes move up together and sometimes they will move down together, and these outcomes are effectively equally likely.
Yet people will observe two assets that have moved in the same direction, usually down, over the same period of time and assume that diversification has failed, when the truth could be the opposite i.e. the assets have behaved exactly as predicted – independently, even though they just so happen to have moved in the same direction.
And here is the catch.
Correlation must be measured over many observations. Technically it is undefined over one observation, say a single day or month, and always plus or minus one (perfectly correlated) over two observations, which makes it meaningless. If you have therefore understood two assets as being uncorrelated, say over time, and then you look at the failure of this diversification over a single observation, you have failed to understand how diversification works.
Let us consider an example to solidify our understanding. The chart below shows the monthly returns of equities relative to bonds over a period of more than 20 years. While the correlation of 0.215 is statistically significantly different to zero, it is not very high, and bonds are generally a great diversifying asset for equities. In March 2020, however, most commentators spoke about the failure of bonds to provide diversification as they fell almost 10% when equities fell about 14%. Unfortunately, looking at a single observation is not meaningful, and you could draw the wrong conclusions about diversification virtues of bonds. For example, in the next worst single month for equities, bonds delivered close to 0% and in the third worst month for equites, bonds delivered more than 4%. This is exactly the behaviour that you would expect from a diversifying asset.
Let us now consider the other misunderstanding. You do not need uncorrelated assets to benefit from diversification. Two assets could be positively correlated – like with equities and bonds above – and still provide diversification benefits, simply because the magnitude of their moves is not identical. This is the case with many shares for example, and represents the benefit of diversifying what is commonly referred to as idiosyncratic risk. Idiosyncratic risk is the risk that is particular to a specific share – as opposed to risk that affects the entire market. It is different to systematic risk, which affects all investments within a given asset class.
Investors can therefore mitigate idiosyncratic risks by diversifying their investment portfolios, as these are, by definition, company specific. Consider another example of investing in the shares of two banks. While there are many factors that will drive the share prices of all banks, there are also many that will affect banks differently, because they could only apply to individual banks. An example of this would be strategy.
If the shares of one bank drop by say 20%, and the shares of another drop by say 10%, that is diversification. Yes, you have lost money on both, but not the same amount. And if you held the same rand value in each, you would only have lost 15% on average, and in aggregate.
You see, if you only held the bank whose shares dropped 20%, your loss would have been 20%, so the diversification worked. If you think that diversification is one asset going up to offset the loss of the other going down, you are confusing diversification with hedging.
While both help to reduce overall risk, they are two very different things. Hedging is the act of removing risk – and unfortunately return as they are two sides of the same coin – whereas diversification is reducing risk by taking on additional risk in a different asset that is not perfectly correlated.
Diversifying the many layers of idiosyncratic risk
So if you now understand what diversification is and how it works, you may recognise that its benefits can be derived by considering diversification at all levels i.e. every little bit of diversification counts. While most managers will espouse the benefits of diversification at the asset class and security level, few will consider the additional diversification benefits to be gained by considering diversification at higher levels, such as at the manager level. You need to understand that manager risk is not rewarded and you would be well advised to diversify this by investing with multiple managers, whether you do this yourself with the help of an adviser, or through a multi-manager fund – but do not confuse this with a fund of funds as the two are not synonymous.
Conclusion
Do not misunderstand diversification to be hedging and be careful about understanding the benefits of diversification over a single period or over the short term. Diversification should be measured over the same period as your investment horizon and not over a short or single period, unless this happens to be your investment horizon, in which case you should not be invested in risky assets to start.
Also understand the many levels at which you can derive diversification benefits. While this may start at a security level, it should not end there. At the extreme you should diversify single manager risk, especially where managers are taking high conviction positions, because there is a chance that they could be wrong.
Key points in this article:
- Diversification remains the one ‘free-lunch’ in investments, as it is unrewarded, and investors can use it to reduce idiosyncratic risks
- It applies at many different levels of unrewarded risk, ranging from individual securities, through asset classes, to the manager level
- It should be measured over multiple periods and over the time horizon of the investor, not over a single period or short-term time horizons
- It should not be confused with hedging, which should involve assets that behave in exactly the opposite way to each other.