Investment diversification – risk of keeping all eggs in one basket

We can easily overdiversify our investments for many reasons, and they are very, very common, even with some of the very largest funds. Peter McGahan explains.
investment diversification - eggs in one basket
Investment diversification: avoid stress and losses by spreading risk.

You will have heard the investment terms: ‘not having all your eggs in one basket’, or ‘spreading your risk’. There is sense in that of course, and if your pension or investment valuations are currently coming through, you will know what that means.

Over the last 34 years, I’ve been through many cycles. ‘History doesn’t repeat itself but it often rhymes’ as Samuel Clemens said many moons ago, but the man you know as Mark Twain didn’t mention that it also hums in between those rhymes. Hum it does.

Samuel (Mark Twain) was born in 1835 when the population of the USA was just 13 million. By the time of his death (1910) the population had soared 600 per cent to over 92 million. (The UK’s population increase was just 134 per cent during that time). It was the biggest explosion of ‘wealth’ in the USA that society would previously had thought unimaginable, and also one of the most dynamic periods in history.

Markets are way more complex in some ways since then but carry many similarities.

The balance of investment diversification

It makes sense to diversify, particularly if you are investing on a hunch, or a ‘celebrity’s ‘advert’ (Google ‘Kardashian $1.3m fine’, if you weren’t cynical up to that point).

The theory of investment diversification comes from trying to buy assets that are not correlated, like my old example of ice cream companies and wellington boot companies. Both should do well in normal conditions, but if it all goes a bit too hot or cold, they balance out each other’s losses.

It is easy to throw the pension in the cupboard and forget about it and hope its grand. I get the reaction. It’s common. It’s stressful and as boring as chewing the newspaper you are reading (or licking the screen!). It is, however, very expensive. ‘It’s only a bad decision’ if I look at it, is a common response, but there won’t be a Tardis to go back and change it when you retire or want to access the money.

We can easily overdiversify our investments for many reasons, and they are very, very common, even with some of the very largest funds.

Often the financial adviser’s job security or potentially the poor products offered by dealing with an adviser who just represents one company can create the problem. In attempt to ‘not underperform’, managers can simply blend with the crowd, and therein lies the biggest risk of over-diversification.

Spreading risk

They pick a balanced fund in one place, a balanced fund in another, and a basket of cheap ‘trackers’ or ETF’s to keep the costs down.

In the end, you could be exposed to the same stocks in different funds, and also many of the same sectors. EG: If you hold the S&P500 index and an ETF in the Nasdaq composite index you are exposed, as the S&P holds 28 per cent of its total in IT stocks already. The market rises in those sectors, and you pat yourself on the back and buy more. You are buying into that current momentum. However, the concentration risk (not diversification) you are buying into will feel more like a wrecking ball patting your back when the market turns.

Each time we add little additions to a portfolio beyond a point we may lower the potential return by more than the risk we are lowering i.e. de-worsification. It is more common than it is not. One assessment we use when deciding which funds to choose is to assess risk, and max drawdown is one of those risks. Max drawdown will show me the largest peak to trough drops in all funds, and often those with concentration risks are those that stick out.

Scattering seeds

Buffet said that risk comes from not knowing what you are doing, and the simple scattering of seeds approach above is an example of that. If your fund charges you highly while throwing the money everywhere, some will land on paths and stony ground, to use another ‘old’ example.

This concentration risk also brings you risks like market liquidity and credit risk. If everyone is exposed in the same stocks and are trying to liquidate (sell) them, they may not be saleable and the price will be plummeting, let alone an individual debtor or group in the same sector defaulting – chaos.

It’s only when the tide truly goes out that you realise who was swimming in the nip. It’s not a good idea nearing November.

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Tags: , , , Last modified: October 20, 2022

Written by 10:55 am Finance