Mark Twain once took exception to the proverb that you shouldn’t put all your eggs in one basket: “Yes do that … and then WATCH THAT BASKET!” So… when it comes to your investments, who is right? The proverb? Or Mark Twain?
Admittedly, watching is also important when it comes to investments. Let’s take the case of someone who owns and runs a hotel and has all her money invested in it. Well, that owner should certainly look after her hotel – and owning and running one hotel is certainly easier than watching, say, ten hotels simultaneously. But of course there are still risks, and some of those are outside the control of the owner: Natural desasters; an appreciating national currency strengthening foreign competition; a weaker economy causing people to spend less money on holidays; …you name it.
If however you add investments from different asset classes, rather than multiplying the number of hotels you run, you can reduce vulnerability to these uncontrollable risks. Which is really what diversification is all about: Mixing different investments within one portfolio in order to reduce risk. How that works? Rarely do different assets (let alone different asset classes) follow exactly the same price movements. In other words: Generally, there is no perfect correlation between the price movements of different investment vehicles. And if you add up the performance of two such vehicles, one offsets some of the price movements of the other. Take the stock of a pure oil explorer which reacts positively to rising oil prices. And combine it with a pure petrochemicals company whose margin gets boosted when oil prices come down. This combination gives you a risk profile that is much less sensitive to the oil price. Or, on a more macro level, mixing stocks with bonds reduces the sensitivity to economic growth – when the economy gets stronger, companies make more profit and their stocks reflect that, whilst interest rates typically rise, negatively impacting long term bonds… and vice versa. And even stocks from the same sector don’t follow exactly the same price patterns, and diversification takes out some of the risks that are specific to the individual companies.
Now, you may think that these shorter term price movements are not so important: if you believe in the long term future of a company, what is the big deal if its stock price falls at some point – you can just hang in until it recovers, right? Well, yes and no. Yes, it may work out that way. But there are two things to consider. In the short term, your money is tied down. You have less liquidity and most of us feel stress when we see the value of our assets falling. And even long term, you don’t really know that things will work out for that company. The longer the term, the less predictable the future and therefore the greater the risk that something will happen which fundamentally changes the outlook (and therefore value) of your stock. The expected return may be the same for one stock compared to a portfolio of stocks. The actual outcome may be quite different. One big accident on one platform in 2010 (Macondo), BP suffered a 50% of value loss which is still not fully recovered; General Electric lost half of its value just in 2017 and now investors aren’t sure whether the company will succeed in the “new energy world”… Some of the companies that used to promise a golden future have delivered on those promises – and others haven’t. And in advance nobody ever knows with certainly which ones are which.
And here is the thing – why wouldn’t you diversify? The beauty is that you don’t have to sacrifice return in order to get lower volatility. The below picture is an illustration using the following example. Say, ten years ago you took a choice. You had 100€ to invest, and you wanted to put it into the DAX index of German stocks. Or into gold. Or 50 into each. (Now, that is not a particularly sophisticated selection of assets, but gold and shares tend to react quite differently to the same economic news, which will make my point). Let’s look at the result after 5 years. By 2012, stocks would have lost some money, and if you invested into the DAX only, the value of your investment was down to 94€ from the initial 100€ (the red line in the chart). Gold on the other hand performed very nicely and would have increased to 226€ (the blue line in the chart). Fast forward to today: In the last 5 years, stocks recovered and the DAX investment would now be worth 162€. Gold on the other hand lost value and the €226 would have come down to 192€. Still a nice profit for those ten years in total, but important to note that with either of those “pure plays” (only gold, or only stocks), there was one 5 year period where you made a loss, and only one where you made a profit.
Now let’s look at two ways to do this the “diversified” way. Firstly, assume you put 50 into gold and stocks each in 2007, and never touched it again. That’s the green line in the chart. Obviously, the total return is somewhat lower compared to the “gold only” option. After all, you make most money if you put all your money into the instrument with the highest return (if only we knew upfront which one that is…). But you made a profit in both the first 5 and the second 5 years, and you had a much more stable return. And now let’s look at the black line. It represents a portfolio where you also put 50 into each stocks and gold in 2007, but after 5 years you sold some of your gold and invested in stocks, just enough to bring those two back to equal value in 2012…. in order to stay true to the original idea of having half of your assets in stocks, and half in gold. This is quite normal practice in professional investing (although it is typically done more frequently, for example annually), and is called rebalancing. Now, for the first 5 years the black line is the same as the green one (no surprise there, as for that period they represent the same portfolio). But in the second 5 years, you now benefit from having bought extra stocks at a cheaper price in 2012. And the total outcome is even a tad better than the pure gold investment. And more importantly, you don’t have the same tremendous ups and downs as you do with stocks or gold only.
For any real portfolio decision, diversification would be a bit more complex and not always yield exactly the same result. But I hope I made my point – I just love that black line, don’t you?