Diversification or “diworsification”?

Most investors understand the importance of diversification within their portfolios.

Done properly, diversification across the main asset classes can significantly reduce risk and volatility, without substantially reducing the potential for returns.

This tends to work because different asset classes behave differently. Negative correlation between asset classes allows risk to be reduced, because when one asset class falls another should rise.

The correlation between asset classes often changes, due to changing market and economic conditions.

A new analysis of data reported in Investment Week has looked at the use of more concentrated funds, investing in a smaller number of underlying stocks, when stock markets are more volatile.

Nomura assessed 226 actively managed funds in the European equity sector. They found that concentrated portfolios outperformed over the past decade, with small periods of significant outperformance.

These short periods of significant outperformance tended to happen at times of major market stress.

Not everyone is a fan of diversification. Warren Buffett famously refers to diversification as “diworsification”, preferring instead a more concentrated approach to stock selection.

What the figures from Nomura could suggest is that there is a time for diversification and a time for greater levels of stock concentration.

Establishing when this time occurs, before it occurs, is the real challenge. It is easier to determine that the markets are more highly correlated with the benefit of hindsight than to accurately and consistently predict they are about to become more highly correlated.

Just like market timing, making decisions to concentrate your equity portfolio is probably an unwise move.

The risks of becoming more concentrated at inappropriate times, combined with the additional costs associated with switching between funds, probably outweigh the potential benefit of investing in a more concentrated portfolio at times of greater market stress.

Photo credit: Flickr/Nomadic Lass