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Diversification – Harder to find?

At its core, diversification is a way to make money more safely. More specifically, diversification helps you reduce the risk of losing the money you’ve invested without reducing your returns. Today Jonathon Mannion from Sandringham Wealth unpeels a few layers of diversification.

By Jonathon Mannion - Sandringham Wealth - Jul 06, 2020

This is a guest post from Jonathon Mannion. Jonathon is a portfolio construction guru and Senior Financial Adviser at Sandringham Wealth.

Investopedia.com defines diversification as “a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk”.

At its core, diversification is a way to make money more safely. More specifically, diversification helps you reduce the risk of losing the money you’ve invested without reducing your returns.

Random Walks

Vanguards’ Burton Malkiel wrote, the investment classic “A random walk down Wall Street” in 1973. The fact that it’s still being printed in 2020, nearly 50 years later, tells us that it’s got real merit. The “random walk” in the title refers to the random nature of the markets, the fact that the chance of your investment going up or down tomorrow is 50/50 – the same as a coin toss, a bet. To illustrate the impact of diversification let’s run with the coin toss analogy.

Assume your portfolio is made up of a single investment, represented by a single coin. Your results rest on a single outcome, you’re either up or down.

Now add another four coins to the first one. The chance of that first coin being up or down remain unchanged, but it’s impact on the overall portfolio result is reduced, it’s only 1 of 5 coins.

Extend that analogy now to something more like a fully diversified portfolio and that first lone coin becomes one of perhaps 1,000. The impact now? Though it will still influence the end result, your portfolio’s return, it is muted because you have spread the risk, diversified.

The good news is that with more investments and more time comes more certainty. You probably know this already – it may be part of the reason you hold ETFs. As a basket of investments, and ETF has some diversification built in. It’s worth digging a little deeper into diversification. In the next couple of posts we will start to consider a range of significant, often hidden risks and how to reduce them.

Managing Risk within asset classes

As an adviser one of the first things I do whether constructing or reviewing a portfolio is to look for concentration, and thus risk. You are likely familiar and comfortable with allocation across asset classes, but it’s crucial to consider diversification within asset classes.

Here’s a simple example – 3 large, liquid, ETFs to cover the international equities  allocation in your portfolio. Whilst I have used real ETFs, this piece on diversification is more how they are combined than the funds themselves and as such I’ve excluded the names.

Fund NameFund Exposure
Fund 1Top 100 Global Shares
Fund 2S&P 500
Fund 3Technology Leaders

Diversified? At some level yes, we have a large range of individual companies, but let’s look at the makeup of those funds based on geography and stock overlap.

Fund 1 consists of global leaders. Made up of large and giant cap as we’d expect from the label.  Skewed heavily towards the developed world – but particularly the US.

Fund 2 is made up of the S&P 500 index. Heavily skewed towards large and giant cap. We know it’s going to be US exposure.

Fund 3 Technology leaders – Heavily skewed towards large cap, but we do start to see the introduction of mid caps in this fund. Unsurprisingly, skewed heavily towards the developed world – but particularly the US.

Geographic exposure

The table below outlines the geographic exposure by Percentage Allocation:

Country ExposureTop 100 Global SharesS&P500Technology Leaders
US70%99%77%
Germany4%0%6%
Israel0%0%4%
Japan0%0%4%
Singapore0%0%4%
UK7%0%0%
Switzerland7%0%0%

If these were bought in equal weights, the allocation to the US is a little over 82%.

Stock overlap

Here’s where time and good quality research are crucial if you’re going to understand what each fund holds and to what degree.

The top 5 holdings of funds 1 and 2 are looking remarkably similar:

Top 100 Global SharesS&P 500Technology Leaders
MicrosoftMicrosoftInfineon Technologies
AppleAppleSplunk
AmazonAmazonMicrochip Technology
Alphabet AFacebookBroadcom
Alphabet CBerkshire Hathaway BServiceNow

Looking deeper than the top 5. Two names, Microsoft and Intel sit in all three funds. Microsoft is in the top 10 holdings of all three fund. Outside of that, a further forty eight names sit in two of the three funds.

If we now take a critical look at the international allocation in your portfolio, it is almost entirely focused on large and giant cap US equities, with a 50% allocation to technology. Geographically, you’ve missed opportunities in Asia, Europe and Latin America. You have limited allocation to mid cap, and no allocation to small or microcaps.

Diversification is multifaceted

Diversification is a conscious spread of geographic, stock specific, industry specific and currency risk. Instead of investing in isolation take the time to read the makeup of the funds, and if you really want to get into the weeds of portfolio construction there are some fantastic tools available to help you look deeper.

The first wave of Covid-19 has rapidly accelerated trends already in motion. The impact this has on your portfolio by way of concentrated risk is important to consider. In my next post I’ll be taking a look at this.

 

This is a guest post from Jonathon Mannion. Jonathon is a portfolio construction guru and Senior Financial Adviser at Sandringham Wealth.

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Diversification – Harder to find?
Jonathon Mannion - Sandringham Wealth -July 6, 2020