Diversification — more than just a free lunch

Instead, we have an in-built bias towards “conviction”. We love to read stories of fund managers who saw something coming that no one else did. And we only usually hear about those who gambled and won rather than those who got it badly wrong. We prefer, in short, reassuring lies to the inconvenient truth that all known information is already incorporated into prices, and that market movements are, to all intents and purposes, random and unpredictable.

Diversification, by comparison, seems, dull and boring. But it’s hard to overstate what a brilliant deal it actually is. It’s been described as the one free lunch investing. But that possibly underplays it. Diversification isn’t a one-off event; it’s a meal to sustain you every day of your investing lifetime.

When most people think about diversification they think about reducing volatility. It certainly reduces different types of risk, including concentration and market risk.

Another advantage is that, because stocks and bonds are inversely correlated — in other words, one tends to go up in value as the other goes down — diversification also gives you a smoother ride towards your investment goals.

But a benefit of diversification that many people aren't aware of is that it also delivers more reliable investment outcomes.

Wei Dai, the Senior Researcher at Dimensional Fund Advisors, conducted a study in 2017 entitled How Diversification Impacts the Reliability of Outcomes. In the resulting white paper, she explained how having a diversified portfolio is critical to capturing the premiums associated with different factors.

Of course, outperformance cannot be guaranteed, but academics have demonstrated how, for example, over the long term, small-cap stocks usually outperform large-cap stocks, value stocks beat growth stocks, and stocks with high operating profitability outperform those with low profitability.

But capturing those premiums is more complicated than it may first appear. Just because, say, small-caps rise by 10% across the board in a particular, that doesn’t mean that every small-cap stock rises by the same amount. Indeed some may produce stellar returns, while others perform very poorly. Predicting, at any one time, which small-cap stocks are going to outperform is extremely difficult. Missing out on the stocks that perform best will mean that you don’t receive the full benefit of small-cap premium.

To make matters worse, taking a concentrated position also adds to turnover and cost, which in turn will further reduce your returns. The answer, then, is to diversify broadly, to stay invested, and to avoid trying to time the market.

Wei Dai then went on to ask, How do different levels of diversification impact the probability of outperformance?

Quantifying probabilities in investing is not an exact science, but the Dimensional study looked at the chances of a range of simulated US large-cap portfolios, with differing levels of diversification, outperforming the Russell 1000 Index, over different time periods. It calculated that a fund with 50 stocks in it had a 69% chance of outperforming the index over 10 years. The figure rose to 92% for a fund containing 500 stocks. But the Dimensional Adjusted Large Cap Equity Index, which includes the full large-cap universe of 1,000 names, had a 96% chance of outperforming the Russell 1000 Index over ten years. In other words, the more diversified the portfolio, the greater the chance of outperformance, especially over longer time periods.

Another advantage of diversification, the study found, is that tracking error declines steadily as portfolios increase in size. Again, this enables the investor to capture the premiums they’re targeting in a more reliable way.

The beauty of broadly passive funds — whether traditional, market-cap weighted index funds or factor-based funds such as those offered by Dimensional — is that they have diversification built-in. To use Jack Bogle’s famous analogy, instead of looking for a needle, you’re buying the whole haystack.

Actively managed funds, by definition, are less diversified. According to the CRSP US Mutual Fund Database, as of December 2015, more than half of large-cap equity funds contained fewer than 90 stocks. Of course, it’s possible for an active manager to identify enough of the future outperformers and discard enough of the losers to beat the index. But the overwhelming likelihood is that, after costs, over the long term, the fund you choose will underperform the market.

Diversification really does make sense — and reducing volatility is only part of it.

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