Don’t put all your eggs into one basket.

No one knows the origins of that age-old idiom, but it provides an understandable explanation of one of the key principles of modern share market investing – Diversification.

Simply put, spreading your investment “eggs” over different investments lessens your risk.  However, diversification is a relative newcomer to investing.  In the first half of the twentieth century, investing was all about maximizing returns, with minimal attention paid to the risk involved.

In 1952, an economics student at the University of Chicago – Harry Markowitz -- revolutionised the investing landscape when he published his doctoral dissertation in which he examined the relationship between the reward of an investment and its risk.

Markowitz, who went on to win the Nobel Prize for economics in 1990, proved there was a mathematical relationship between risk and reward in investing.  He proposed the notion that rather than attempting to control risk in a single investment, risk could be more effectively managed with a portfolio of multiple investments.

What he was looking for was correlations between the price movements of different types of investments.  The idea was to reduce investment risk by finding investment vehicles whose price would not move in the same pattern in response to market conditions.

Perhaps the best example to illustrate the value of his discovery is price movements in reaction to rising oil prices.  As the price of oil rises, one would expect the shares of an oil producing company, like Westwood Petroleum to rise; and the shares of an oil consuming company, like Qantas Airlines to fall.  Here is a 1-year chart comparing the price movements of those two companies.

Today, Markowitz’s work has evolved into what we now call Modern Portfolio Theory.  The chart above is truly worth a thousand words.  Investors placing all their eggs into the Qantas basket are not happy right now.

Granting the principle that one should invest in more than one “basket” raises two questions.  First, what about investing in “boxes” and “bags” as well as baskets? And second, just how many baskets, boxes, or bags are enough?

Modern portfolio theory calls for investors to spread their investing dollars across different classes of assets – shares, fixed income securities, and cash.  Think baskets, boxes, and bags!  Bonds have the supposed advantage of guaranteed fixed income in a defined period of time, although they do carry some credit risk of default and risk from interest rate rises.  Cash investments usually find their way into term deposits or money market funds.  

Some investors, however, cannot resist the lure of higher returns through share market investing and restrict their investing to shares and cash.  They have significant research evidence to support what they are doing.

In his book, Stocks for the Long Run, Professor Jeremy Siegel of the Wharton School of Business at the University of Pennsylvania in the United States studied the performance of share investing versus investing in bonds, government securities, and even gold.  He went all the way back to 1802 to find that shares yielded higher total returns than any other investment class in that 200-year period.

However, even those investors who opt to limit their investing to the share market, with some cash investment reserves, look to diversify their holdings.  But how much diversification is enough?  Could you call a portfolio including only shares of WPL and QAN a diversified portfolio?  If not, how much is enough?

Some experts claim shares in 20 companies is a desirable upper limit.  If 20 were good, wouldn’t 25 be better?  Is it possible to have too much diversification?

In his landmark book, Common Stocks and Uncommon Profits, American investor Philip Fisher devotes two Chapters towards discussing a series of Don’ts for Investors, one of which is Don’t Overstress Diversification.  Here is what he had to say:

This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them.  For example, among investors with common stock holdings having a market value of a quarter to a half million dollars, the percentage who own twenty-five or more stocks is appalling.  Rather it is that in the great majority of instances only a small percentage of such holdings are in attractive stocks about which the in investor or his advisor has a high degree of knowledge.  Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.  It never occurs to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.

Fisher’s prowess is unchallenged as an investing guru.  Despite his reputation, the warning he issued about the downside of diversification back in 1958 did little to change conventional wisdom regarding portfolio theory.  Diversification has achieved the status of a cardinal rule, never to be broken.

Yet even under the best of circumstances, a fully diversified portfolio rarely rises above the returns you might get from passive index investing.  Think about that.  Over time, diversification will lessen the pain from a drop in the share price of a Qantas Airlines.  However, that risk protection in Qantas is going to dilute the reward performance of shares of Woodside Petroleum.

Contemporary conventional wisdom says if you do not have the time to actively manage your investments in a diversified portfolio, you should stick to investing in an ASX index fund.  According to some experts, index funds are the easiest way to diversify.

Is that all there is?  Actually, no it is not.  There is a third alternative called Focus Investing.  Next week we will look at what it means to build a focused portfolio, an alternative to traditional asset allocation models.

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