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Diversification is essential

Diversification is the principle of spreading your investment risk across various asset classes, regions and sectors. We ensure that our investment portfolios hold the shares and bonds of many companies and governments in many countries around the world.

We choose to invest our clients’ assets in many thousands of individual investments because we believe in the power of capital markets rather than individual predictions or judgments. This means that the negative and positive influence of each individual investment is reduced, producing, on aggregate, less risk in our portfolios.

Diversification across an investment portfolio remains one of the cornerstones of a sound investment strategy. The idiom “do not hold your eggs in one basket” is particularly pertinent in this instance. 

However, there is far more to be achieved through diversification than simply mitigating systemic risk. It has been researched and documented on many occasions that a correctly diversified portfolio has the ability to enhance market returns.

Markowitz and “Portfolio Selection”

Although the concept of diversifying risk has been recognised for centuries, it was back in the 1950s that the idea was formalised within the financial arena by Harry Markowitz in his 1952 paper “Portfolio Selection”. 

Markowitz used mathematical formalisation to postulate that the investor should look to maximise the expected portfolio return, while minimising the variance of return[1]. This concept may seem elementary within the modern investment community; however, Markowitz's paper remains a core basis for many investment philosophies today.  

Since the 1950s, there have been a number of developments to the theory, of particular relevance is the idea portfolios will yield higher returns through diversification[2]. According to a paper by Booth and Fama, given constant asset allocation weightings, diversification has the ability to add to the portfolio’s compound return.

When it comes to diversification, it is important that all facets of the portfolio are covered. More specifically, diversification should look deeper than simply asset allocation. The investment should also be spread across market sectors, credit ratings, maturity structures and, importantly, geographic regions. 

International diversification, or a move away from domestic markets, should be a core consideration and failing to do so is often referred to as a “home” or “domestic” market bias.

Thus, while diversification will be a familiar concept to most, if undertaken correctly, a well-diversified portfolio will not only mitigate risk but also enhance portfolio returns, and as Markowitz postulated, maximise returns while minimising risk.

[1] Rubenstein, M, “Markowitz’s “Portfolio Selection”: A Fifty-Year Retrospective”, The Journal of Finance (2002)

[2] David G. Booth & Eugene F. Fama, “Diversification Returns & Asset Contributions”, Financial Analysts Journal, May/June 1992

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