Is high level portfolio diversification enough?: OpinionTech by Lensell
The LENSELL team has released its third article in the “OpinionaTech” leadership series.
This article shows a worked through simple portfolio example, arguing – using the insights from advanced portfolio optimization software Diversiview – that high level diversification across industry groups is not enough.
“For many years, the traditional advice for diversification has been to spread investments across different asset classes (stocks, bonds, gold, managed funds, etc.). That is, split them into defensive and high-growth investments, spread them across other financial markets geographically, divide them into different industry groups, etc.
While such an approach is a good way to start your diversification journey, it’s not enough.”
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The answer to the question in the title is No and this article will show an example of why that is the case.
For many years, the traditional advice to diversification has been to spread investments across different asset classes (stocks, bonds, gold, managed funds etc), to split them across high growth and defensive investments, to split them across different financial markets geographically, to split them across different industry groups, so on…
That is because common sense tells us that different asset classes will respond differently to different market events, or that stocks from different countries or different industry groups will behave differently when reacting to economic, social or geo-political crises.
We argue that, while that approach is a good way to start your diversification journey, it is not enough. Our entire world is connected. Companies from different countries work together, supply chains run always across many industry groups, new investment types appear often (e.g. ETFs, cryptocurrencies), and many other factors coexist that deem the traditional high level approach to diversification just ‘no longer good enough’.
It is, therefore, our view at LENSELL that when looking for a proper diversification of investments one should go to the roots and apply the principle introduced by Harry Markowitz in 1952*. That is, in order to properly diversify an investment portfolio and mitigate the inherent individual risks of the individual investments, one should look for investments that are not correlated or that are negatively correlated. It means that knowing the granular correlations between individual investments is a critical aspect of diversification.
In this article we will exemplify one of the scenarios, when high level diversification by industry groups alone is not sufficient, and show how the level of diversification for the portfolio will change depending on the stocks selections in each group.
Meet Diana and Tom.
They are good friends, passionate about the same type of activities and having similar values that drive their lives. They have, therefore, invested in the same 5 industry groups that appeal to their personal interests and return expectations. See Fig1 below.
Figure 1 Diana and Tom, the characters in our example, and their preferred 5 industry groups.
Diana selected the following stocks from the 5 groups: CBA (Banks), STO (Energy), IMM (Pharmaceuticals, Biotechnology & Life Sciences), LLC (Real Estate) and XRO (Software & Services).
Tom selected the following stocks from the 5 groups: PPM (Banks), WPL (Energy), TLX (Pharmaceuticals, Biotechnology & Life Sciences), HDN (Real Estate) and APT (Software & Services).
See Fig2 below for a detailed view of their investments across the 5 industry groups.
Figure 2 Individual investments for Diana’s and Tom’s portfolios across the same 5 groups
Does having invested in the same 5 industry groups mean that they’ve achieved the same diversification?
No, it does not, because the actual deep, granular diversification at investment level (as shown by the analyses run in Diversiview) tells a different story. See Fig3 below.
Figure 3 Individual correlations and ratings for Diana’s and Tom’s portfolios
As it can be noticed, Diana’s selections have 3 positive (>0.25), 3 negative (<0) and 4 weak positive (between 0 and 0.25) correlations, while Tom has 1 positive, 3 negative and 6 weak positive correlations.
In Diversiview, we also calculate an overall diversification rating where positive correlations are penalised, which gives a ‘4.3 out of 5’ rating for Diana’s portfolio, and a ‘4.8 out of 5’ rating for Tom.
In other words, Tom’s portfolio is better diversified compared with Diana’s portfolio. This shows that the granular, deep diversification can be different depending on the selected individual investments even when they come from the same set of industry groups.
Another myth that exists and it can be debunked with this example is that portfolios that are better diversified automatically have a lower risk. As it can be seen in the Table 1 below, Tom’s portfolio, although having a better diversification that Diana’s, is in fact more volatile therefore more risky. That is because portfolio’s volatility is a function of several data points: the individual investments’ volatilities, the weights in the portfolio and the correlations between individual investments. In this example, APT has a high volatility which impacted on the total portfolio risk even when the diversification level was high.
Overall, Tom’s selections from the 5 groups also bring a better expected return than Diana’s, as well as better Sharpe ratio, better portfolio Beta and better portfolio Alpha.
Table 1 Portfolio performance indicators for Diana and Tom in our example
In conclusion, to answer our original question and the topic of this article – a high level diversification across industry groups is not sufficient for making decision, as shown in this example. Different selections of stocks from the same groups will create unique portfolios, each with their own diversification level and performance indicators. Investors need to do more detailed research about their portfolios rather than taking high level approaches, as future returns will depend on that.
Note 1: While this example only refers to high level diversification by industry groups, we argue for the same importance of deeper, data driven research when diversifying across international markets, asset classes or investment types.
All indicators, diversification and graphs have been obtained using our application, Diversiview. It helps investors analyse their portfolios in seconds, use the insight to make better informed decisions and find ways to optimise their investment portfolios.
Note 2: The stocks mentioned in this article are for exemplification purposes only. We do not endorse, recommend or offer opinions about any of them. The example is provided for information purposes only, it should not be considered financial advice nor solely relied upon for making any trading decisions. Please consult a finance professional before buying or selling any securities or before making any other changes to your portfolio.
For any questions about this article please contact the author, Dr Laura Rusu, at email@example.com. Alternatively, subscribe to LENSELL’s newsletter to receive notifications when new articles are published and to keep up to date with product developments.
Check out the YouTube video showcasing the example.
* Portfolio Selection, Harry Markowitz, The Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pp. 77-91. PDF.
Contact the team with any questions at: firstname.lastname@example.org or email@example.com.
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