The three best ways to diversify in a crisis

Diversification is motherhood and apple pie for investors. Since Harry Markowitz, father of modern portfolio theory, called it ‘the only free lunch in finance’ in the 1950s, everyone has agreed that it is a good thing. I’ve certainly banged on at length over the years about the merits of holding a balanced portfolio. And the current ‘commodities up, shares down’ environment has done nothing to change my mind.

The latest Credit Suisse Investment Yearbook, put together before war and sanctions created this divergent investing landscape, makes a timely contribution to our understanding of diversification. Although it broadly confirms that putting your investment eggs in a range of baskets is a sensible approach, it draws one unexpected conclusion and offers a warning that the benefits of balance may be harder to achieve in future.

There are many ways to diversify a portfolio but the three most important are across individual stocks, asset classes and geographies. Coming from a fund management background, I tend to take as read that investors realise the importance of diversifying away individual company risk. The evidence suggests, however, that most individuals’ portfolios are far too focused. A study of accounts at a large US discount brokerage a few years back showed that the average holding was just four stocks, with younger and less sophisticated investors holding the most concentrated portfolios.

That’s a bigger problem than it seems. It’s not just about the risk that the complete failure of one investment can wreck the performance of an undiversified portfolio. Rather it’s the fact that the majority of shares actually underperform cash over time. Since 1926 it’s been the stellar performance of just a small number of shares that have accounted for all the gains achieved by the US stock market as a whole. The more concentrated your portfolio is, the less likely you are to have an exposure to that handful of top performers.

That’s not to say that everyone should simply invest in tracker funds that attempt to capture a tiny slice of every company’s performance. If an investor genuinely has skill in identifying likely outperformance (which is the point of active fund management) they should avoid what Peter Lynch famously called ‘diworsification’. But many fund managers hedge their bets in the interests of career preservation. The average US equity fund in 2012 held 176 stocks which does not indicate a high degree of confidence in their manager’s stock-picking ability.

The report’s analysis of geographic diversification, investing outside your home market, is where the unexpected conclusion appears. It is the fact that for one very important group of investors diversification would have been counterproductive. Professors Marsh, Dimson and Staunton, who crunch the numbers for Credit Suisse, argue that over the past 50 years American investors would have actually done better by sticking to their home market and ignoring the rest of the world. This is a consequence of the consistently superior performance over that period of Wall Street.

For investors based in other markets, including our own, the benefits of investing more broadly are clearer cut. The sub-par performance of the UK stock market, which remains no higher today than it was at the peak of the bubble in 1999, is a salutary reminder of the risks of home bias. Just in the past couple of weeks we have seen how a geographically balanced portfolio has helped investors navigate the Ukrainian storm. The S&P 500 has moved sideways while a market closer to the action such as Germany’s DAX index has fallen into bear market territory, down more than 20pc from its recent high.

One reason that US investors have been able to shun investing globally is the fact that Wall Street accounts for 60pc of the value of all the world’s stock markets put together. The other is that the American market is more diversified than most, providing investors with access to a wider range of industrial, financial, consumer and technology sectors than any other. That said, one of the reasons why the UK has fared better than its European counterparts recently has, ironically, been its lack of diversification, weighted as it is towards the energy and commodity sectors that have performed best.

The third form of diversification, between different asset classes, has been particularly helpful to investors in the past 20 years because the two most important assets, bonds and shares, have been notably uncorrelated in this period. It has always been the case that a balance of the two has helped investors reduce risk, but the recent environment of falling real interest rates, accommodative monetary policy and low inflation has been unusually favourable.

What is less clear is whether the new backdrop of high and rising inflation, and rising interest rates, will be so kind to investors. During the past year there have been more occasions when stocks and bonds have moved in tandem. This is a problem for investors who have come to rely on the smooth ride afforded by so-called 60:40 portfolios that blend shares and bonds. If bonds can no longer be relied on as an effective diversifier, investors will have to rethink their asset allocation. They will need to look to cash, commodities, property, inflation-linked bonds, gold and maybe even bitcoin as the balancing elements in their portfolios.

At times of crisis, it can feel like it doesn’t matter what you own because investors sell what they can rather than what they particularly want to. These moments of panic tend to be short-lived, however, and should not distract investors from the long-term benefits - psychological as well as financial - of holding a well-diversified, balanced portfolio. There are no free lunches in investment, but diversification comes close.

Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63.