In my overview of diversification I commented that my attitude to risk was evolving as my financial objectives began to shift from wealth creation to wealth preservation. I concluded with three questions which effectively asked how much diversification is right for me and how should I structure my investments to achieve that degree of diversification?
The benefits of diversification can be summed up in two sentences:
1. opportunity to improve returns through periodic rebalancing of asset classes which have negative or low performance correlation. In effect there is an element of forced buy (comparatively) low and sell (comparatively) high built around the idea of having a target asset allocation;
2. potential to reduce risk by spreading wealth across multiple assets and multiple asset classes. This reduces the impact of material or catastrophic losses on overall performance.
Diversification has been described as the only free lunch there is when it comes to investments. Academic studies point to the fact that a diversified portfolio which is periodically rebalanced will produce better risk adjusted returns than an undiversified portfolio. I certainly do not have the academic or professional qualifications to dispute this. However, it seems to me that diversification has some disadvantages:
1. more assets means more time spent researching, monitoring etc;
2. more asset classes means that a wider range of knowledge and experience will be needed to monitor a portfolio;
3. more assets and more asset classes means less time spent on each investment decision;
4. more asset classes and more assets mean more money allocated to investments which are not the first choice assets.
After a fairly long debate with myself, I ended up deciding to view diversification as a means of managing two different types of risk:
1. risk that the portfolio will be impacted by negative correlated returns (which is what happened from late 2007 to late 2008) - effectively that all of my asset values move against me at the same time;
2. risk that individual assets will have large negative returns (e.g. individual companies become insolvent).
But, I find that I am still comfortable having a degree of concentration that is inconsistent with traditional portfolio management. Specifically, I prefer to have a high concentration of assets invested in economies that are growing rapidly and have governments that manage their finances prudently (i.e. are not heavily in debt and perpetually spending more than they can afford without resorting to punitive taxation).
Some investors have ready access to very broad asset class mutual funds with very low expense ratios (Vanguard etc) which enable them to construct very simple portfolios and rebalance very easily. Sadly, such funds are either not available to Hong Kong residents (e.g. Vanguard) or are difficult to access or are subject to offshore taxes (e.g. US ETFs). While there are some ETFs available in HK for a number of reasons it is not possible to construct a properly diversified portfolio made up exclusively of such products. There are plenty of actively managed funds that come complete with front end loads and very high expense ratios - which render them unappealing. In short, the easy solution is not readily available.
So how, and to what extent, should I address the two identified risks using diversification?