The Diversification Debate

In addition to the question of how many stocks they should own, another similar question many investors ask is how many funds or asset classes they should own. In a recent Financial Times column, David Stevenson offers some interesting data on the topic, as well as some comments from top strategists.

The “proper answer” to those questions, Stevenson says, is to follow the modern portfolio theory developed by Harry Markowitz, which “suggests that you look at risks and returns, alongside volatility, and then compute something called ‘an efficient frontier’ of different assets, allocated sensibly, in an optimised fashion.” But, he adds, many of the top financial minds in the world — including Markowitz himself — don’t do that. Markowitz actually once said that he regretfully split his portfolio 50/50 between bonds and equities.

“He’s not alone,” Stevenson continues

Modern risk analysis founder William Sharpe, for example, has said simply that he invests in large stocks, small stocks and international stocks.

So is there empirical data on how many funds or asset classes is enough? Stevenson says two studies, one performed by U.K. financial planner James Norton and the other by U.S. strategists Paul Merriman and Richard Buck, found that eight or nine funds provide the best risk-adjusted returns. Norton “started with a classic 60/40 split (Citi Bond index and FTSE all Share) which produced an average annualised return of 8.83 per cent a year with volatility (standard deviation) of 9.58 per cent,” Stevenson writes. “He then progressively added funds until he got to eight (FTSE All Share, MSCI World index exc UK, emerging markets, value and small cap for both the UK and the World), which produced a higher annual return – 9.91 per cent – but with almost exactly the same volatility: 9.69 per cent.”

Others think that’s too high. “Most of the advantage of diversifying happens with three or four significant positions in seriously cheap assets,” strategist Rob Arnott said. “If you go beyond ten, you’re deluding the opportunity set. You’re reducing your ability to add value.“

Tim Bond of Barclays Capital, meanwhile, says overdiversifying can be very dangerous if the best opportunities are in special, smaller areas of the market — as he says is happening now with China’s infrastructure boom and the new carbon lite economy. In such instances, diversification is “literally the worse possible solution to your investment needs,” he said.

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