Diversification

Select a few uncorrelated assets for the best balance of volatility and performance


Conventional
asset allocation

Typical asset allocation of UK institutional investors at the turn of the Millennium

Diversification

The chart alongside shows conventional asset allocation for UK funds. Our research shows that it is not worthwhile widely diversifying a portfolio of funds in this way.

  • On the one hand the benefits of reducing volatility rapidly decline as the number of holdings increases. We calculate that one bond fund combined together with two low-correlated equity funds generates only 20% higher volatility than a typical UK managed fund.
  • On the other hand increasing diversification reduces potential returns by including under-performing markets in the portfolio. One cannot get rid of the unattractive parts of a managed fund without selling the entire fund.
 
 

 

 

 

 

 

 

 

 

 

 

 

 

The benefits of diversification decline disproportionately>
Check the table alongside for your financial health

Avoid highly correlated combinations of assets

Correlation

The danger of this strategy is that the funds chosen on their investment merits may be closely correlated with each other. The table below shows how to minimise this danger.

This correlation matrix shows the relationships between the principal bond and forex markets as well as equity regions, sectors and investing styles for which Investors RouteMap generates recommendations. Correlation is defined as the proportion to which one market reacts in sympathy with another as measured by monthly price changes in market indices measured in US$ over the past 15 years.

Acute danger is colour-coded in red and indicated by high numbers approaching 100%. Falling danger levels are colour-coded in the red to green spectrum. Low and negative numbers colour-coded in green indicate minimal danger of correlation. Please note these observations: -

  • Bond and forex markets have little correlation with anything else, except between £, Euros and their respective bond markets.
  • While significant correlations exist among equity markets, Gold and Resources provide the most effective diversification by sector, while Japan provides the best diversification by region.
  •  The apparent correlation of Growth and Value investing styles with each other and with other equity assets is a statistical anomaly as these two styles only began to diverge dramatically since the technology bubble developed.

The benefits of risk reduction decline with diversification
 
Volatility of a dynamically diversified portfolio compared to a UK-based managed fund

Volatility

The charts shows what happens to volatility when the number of equity funds is increased from one to five funds in each category. Volatility is defined as the standard deviation of monthly changes in market indices measured in US$ over the past 15 years. The coloured lines show the level of volatility for each equity category compared that of a typical UK managed fund. Regions are in red, sectors are in green and investing styles are in purple.

This exercise in 2000 was designed to be as difficult and conservative a test as possible.

  • A quarter of the portfolio is invested in 10Year UK Gilts. First, that is a higher proportion than the 18% held in all fixed-interest securities and cash by the typical UK managed fund. Second, this is most volatile end of the yield spectrum. Third, gilts are the most volatile of OECD government bonds, other than Japan.
  • Within the equity portion, the most volatile asset is bought first in each category. i.e. Japan among Regions, Growth among Styles and Technology among Sectors. The remaining assets in each category are added in declining order of volatility. If the least volatile assets were bought first, the portfolio would record even lower volatility. Indeed if only the least volatile asset in each category were bought, the portfolio would match the managed fund for volatility.

This principle of dynamic diversification can also be applied to the selection of individual countries. If a selection of highly volatile countries are combined, then the portfolio will display a lower overall level of volatility, especially if the countries are chosen from uncorrelated areas of the world. Thus Latin America as a whole has lower volatility than either of its two dominant markets, Brazil and Mexico.

   

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Next Class

Dynamic Diversification is part of the free international investment seminar. Just follow the classroom signs alongside. At the end of each class, there is a sign to the beginning of the Next Class. You can join the classes at any stage, but logically, it is best to start at the top of this page which is the beginning of the series.