When it comes to investing, there’s a saying that “diversification is the only free lunch.” This idea, credited to Nobel Prize-winning economist Harry Markowitz, is at the heart of how we manage your wealth at Saxe Coburg. But what does diversification really mean, and why does it matter for your investments?
Let’s break it down in a way that’s practical, relevant, and easy to understand – without the jargon.
What is diversification?
At its core, diversification means not putting all your eggs in one basket. Instead of relying on a single investment or type of asset, you spread your money across a range of investments. The goal is simple: to achieve better returns without taking on unnecessary risk.
The key insight is that different investments behave differently at different times. Some may do well when others are struggling. By combining these, you can smooth out the ups and downs, helping to protect your wealth through changing market conditions.
How does diversification work?
To illustrate, imagine two companies: Ice Cream Co. and Umbrella Co. Both make the same profit over a year, but their monthly profits depend on the weather. When it’s sunny, Ice Cream Co. thrives, but Umbrella Co. struggles. When it rains, the opposite is true. If you owned both companies, the profits would even out, giving you a steadier return than if you owned just one.
This is the magic of diversification: the variations in the performance of each investment can cancel each other out, reducing the overall swings in your portfolio.
Real-world example: Shares and Bonds
Let’s look at a real example. From 1996 to 2016, global bonds rose 130%, while US shares (equities) rose 275%. Both were volatile, but their returns didn’t move in lockstep-they were uncorrelated. If you’d invested equally in both, you would have earned a total return of 202%, with much less volatility than either investment alone. In fact, this combined portfolio had 28% less volatility than just bonds yet delivered a much higher return.
This runs counter to what many people expect: that higher returns always mean higher risk.
Diversification can give you more for less-higher returns with less volatility.
But does diversification always work?
It’s important to note that the relationship between different investments can change over time. For much of the 20th century, shares and bonds often moved together, making them less effective as a diversification pair. There have also been long periods when bonds performed poorly – such as between 1949 and 1981, when US government bonds lost 67% of their value.
This is why we don’t rely on just one type of investment or one historical pattern. Instead, we look for a range of assets that have shown the ability to deliver acceptable returns for their level of risk-and, crucially, that don’t all move in the same direction at the same time.
How we build diversified portfolios
At Saxe Coburg, our approach is to carefully select investments that pass two key tests:
- Return quality: Does the investment offer a good return for the amount of risk involved?
- Correlation: Does the investment behave differently from the other assets in your portfolio? In other words, will it help smooth out the bumps when markets get rough?
We use these tests to find investments that can work together to deliver strong, steady returns, rather than relying on any single “star performer.”
Examples from our research
Let’s look at two funds we use:
- Fund 1: Invests in Australian shares. It tends to move in the same direction as global share markets, so it doesn’t offer much diversification benefit. However, it has delivered strong returns -15.8% per year since 2019, compared to the market’s 12.7%. We use this fund to replace the market, not to diversify away from it.
- Fund 2: Invests in global shares, but with a different strategy. Its returns don’t closely follow the overall market (the correlation is 0.34, which is considered weak), and it has delivered 19.8% per year since inception. By combining this fund with the global market, the overall volatility of the portfolio drops, and returns increase.
For example, if you put half your money in Fund 2 and half in the global market, your portfolio’s volatility drops to 13.1% (lower than the market), and your return rises to 15.6% per year (much higher than the market). Over time, this leads to significantly higher total gains, with smaller losses during downturns.
The more, the merrier
This principle doesn’t just apply to two investments. Every additional uncorrelated investment you add to your portfolio increases the potential for diversification benefits. In some of our portfolios, we include up to 20 different funds. Over the past decade, our growth portfolios have delivered slightly higher returns than the global share market, but with a fraction of the risk.
The challenges of diversification
Diversification isn’t a set-and-forget strategy. The relationships between investments can change as markets and economies evolve. That’s why we continually research and review the investments in our client’s portfolio, looking for new opportunities and monitoring the risks.
We also recognise that not all “diversifiers” are created equal. Some investments may offer low correlation to the market but deliver poor returns, which can drag down your overall results. Our focus is on finding assets that offer both diversification and strong return potential.
Diversification isn’t a set-and-forget strategy. The relationships between investments can change as markets and economies evolve.
What does this mean for you?
- Smoother ride: Diversification helps reduce the ups and downs in your portfolio, making it easier to stay the course during turbulent times.
- Better returns for the risk: By combining investments that don’t all move together, you can achieve higher returns without taking on more risk.
- Adaptability: We continually monitor and adjust your portfolio to ensure it remains well-diversified as markets change.
Final thoughts
Diversification remains one of the most effective tools for building and protecting wealth. It’s not about chasing the next big thing or relying on a single strategy. Instead, it’s about building a robust, resilient portfolio that can weather whatever the markets throw at it.
At Saxe Coburg, our mission is to help you achieve your financial goals with confidence, through careful research, disciplined portfolio construction, and a relentless focus on managing risk and return. If you have any questions about your portfolio or would like to discuss how diversification can work for you, please get in touch with Mark or Sam.
This article is intended to provide general information and does not constitute financial advice. Please speak with your adviser before making any investment decisions.