Five myths of diversification

Diversification is one of the basic principles of finance, but it’s also often misunderstood. As one of the few genuine ‘free lunches’ in finance, it’s worth busting some of the myths around diversification to clear up these misunderstandings. In this wire, we outline five common myths about diversification. 

#1 - Investors are better off sticking with the familiar

Investors are biased when it comes to selecting assets. For instance, an investor is more likely to invest a large amount of money in domestic equities despite the potentially larger returns that can be achieved from international portfolio diversification. Investor biases, including personality and psychological traits, tend to significantly influence financial decision making, prompting many investors to stick with what they know rather than venture into unfamiliar territory.

Familiarity bias negatively affects overall portfolio diversification.

The familiarity can be linked to overconfidence, where investors are biased about their knowledge of the future value of investments. Overconfident investors may invest too much in an asset that they think they know well, which may be a reason for the tendency to stick to domestic assets. Therefore, sticking with the familiar may be a worse option in the long term for investors, and they should consider diversifying beyond the known.

#2 - Diversification is only for investors

Investors and the financial community should not be the only ones focused on making sure they properly diversify. Global economies and companies should also pay attention. Countries that are rich in natural resources, for example, have built successful economies based on commodities.

But as commodity prices move lower, these economies must find new sources of growth. Diversification of economies should entail entry into new industries and new markets. This can be facilitated with their core existing products. Policymakers and regulators can play a vital role in helping countries to diversify their economies and attract investment. Investors should consider how diversified a country actually is when they examine regions.

The same is true for companies.

A company with a business model that relies on one product or service for most of its revenue is likely to be a riskier option than a company that has a diverse range of strong offerings.

While some companies can thrive based on one product or service, they can have a more difficult time recovering from setbacks than companies with a diversified business.

#3 - The range of securities on an index offers substantial diversification

While passive investing has its merits, the rise of index investing has contributed to higher correlations among stocks in an index. The higher the correlation, the more a security is linked to another, and the greater the risk. If one fails, it could, for example, create a “domino effect.” The correlation within indices has quadrupled since the mid-1990s as a result of index investing.

If investors are not careful, they may end up impairing their ability to diversify equity risk in their portfolios.

Although the impression is that indices can help diversify equity risks, this is only true when risk is also fairly distributed. The more one stock moves in lockstep with another, the less diversified a portfolio will be.

One of the conditions in which markets work best is when people think and act “not in unison but independently of one another,” according to researcher Amin Rajan.

#4 - The popularity and perceived simplicity of an equal-weighted portfolio is ideal for portfolio optimization

When evaluating a portfolio optimization strategy, there are several considerations that would be too lengthy to discuss in one paragraph. But there are general themes about how to approach this complicated subject. Let’s start with the basics.

Equal-weighted portfolios can be a helpful starting point, but it is not always a strong strategy for portfolio optimization. It could be used as a base case scenario to help establish a framework for evaluating some more robust approaches such as using ex-post or ex-ante volatility measures to establish overall allocations. Or investors might consider establishing different weights by asset classes and using historical volatility to adjust those weights, and then re-adjust those weights when appropriate under evolving market conditions. This robust approach involves using historical data to establish overall allocations while incorporating some forward-looking estimates that can help manage risk.

Researchers have found that that the use of robust portfolio optimization techniques generates an overall improvement to investor portfolios when compared to simpler portfolio constructions such as equal-weighted or market cap-weighted strategies. Sharpe ratios for optimized portfolios that were based on robust risk parameters and agnostic return parameter estimates were higher than ratios in cap-weighted and equal-weighted portfolios. By properly addressing risks, investors can achieve meaningful diversification.

Simpler is not always better when it comes to portfolio optimization.

Consideration of a larger number of factors and a more robust approach tends to lead to better portfolio results.

#5 - Investors have shied away from diversifying into alternatives following the global financial crisis

Alternatives, which include hedge funds, were relatively unregulated compared to more traditional investment vehicles in the years before the financial crisis. As a result, there was speculation that investors would become more cautious, but growth of alternative assets has, in fact, increased from 2007 to today. In addition, alternative investments saw smaller drawdowns when compared to stocks in 2008 when correlations across almost all investments converged.

Global economic growth has further increased investor appetite for long-term assets in alternatives, which can be customized, offer increased diversification and generate genuine alpha.

This has put a spotlight on alternatives as investors continue to increase their allocations to the asset class.

Alternative assets are projected to grow between $13.6 trillion to $15.3 trillion through 2020, according to PwC. High performance of capital markets driven by accommodative monetary policies and stable improvements in gross domestic product (GDP) would push alternatives towards the higher spectrum of expected growth. A normal correction in the capital markets, along with a possible rise in U.S. and European interest rates, could lead to a number that falls within the lower range, but nonetheless, there should be growth in alternative assets overall.

Alternative asset managers have taken steps to improve their ability to meet the evolving demands of investors. Hedge funds, for example, seek greater alignment of levels by trading fee levels against assets under management (AUM) and liquidity. Alternative asset managers have also launched more permanent capital vehicles, such as business development companies (BDC) and real estate investment trusts (REITs) and public vehicles to improve capital base stability.

The growth of the alternatives universe can benefit investors, but they should also be aware of the nuances of the alternatives market and engage with experts who can help them navigate the alternative manager universe

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