Sometimes investors have to ask themselves a few awkward questions, and this is one of those times. You may think that your portfolio is diversified, sheltering you from storms. But could this be an illusion?
Harry Markowitz, the American economist who won a Nobel Prize in 1990 for work on the subject, described diversification as ‘the only free lunch in finance’.
‘Don’t put all your eggs in one basket’ – an appropriate analogy for the Easter weekend – is often put forward as a basic rule of investment, but it is not quite as straightforward as the homespun proverb suggests.
Peter lynch, another American guru, argues many people may be more ‘diworsified’ than diversified. They tend to put money into similar or ‘correlated’ investments that would suffer the same fate in a downturn.
The main reason to be alert to the dangers of ‘diworsification’ is the mounting sense of trepidation among fund managers worldwide.
The latest Bank of America survey of these professionals reveals pessimism about the global economic outlook, amid concern that we may face an era of stagflation, a toxic mix of rampant inflation and low growth. This week inflation hit 7 per cent in the UK and 8.5 per cent in the US.
Duncan MacInnes, manager of the defensive Ruffer investment trust, suspects many investors are anything but diversified and so may be thrown off course by the hazards that could lie ahead.
‘More than ever, it is necessary to be humble in the face of uncertainty – and to build a portfolio, first to survive, and second to thrive,’ he says. Ruffer (in which I am an investor) owns BP, Shell and Vodafone, gold mining shares, US and UK government index-linked bonds, and cash.
Until not so long ago, a portfolio composed of 60 per cent shares and 40 per cent bonds was seen as ideal for an investor prepared for moderate risk. When shares prospered, bonds fared less well and vice versa – not a free lunch, but something close to it. Increasingly, however, shares and bonds have become correlated. Higher inflation and interest rates make bonds look less attractive.
No consensus has emerged on the replacement to the 60/40 split devised in the 1950s.
But a contemporary version might be made up of 45 per cent shares, 25 per cent bonds and 30 per cent alternative assets like commodities, infrastructure and property. You may, of course, be willing to take your chances with your current set-up, siding with the stance of that other veteran American, Warren Buffet, that ‘diversification makes very little sense for those who know what they’re doing.’
But are you confident that you are backing shares in companies with pricing power? Jason Hollands of Bestinvest comments: ‘if you have money in several funds with a similar style, such as those focusing on high-growth companies rather than dividend-generating stalwarts, you may find that these funds have overlapping holdings in Apple, Microsoft, Amazon, Facebook and Alphabet.
‘You are doubling up your bets rather than diversifying.’
For example, Microsoft is the largest holding in two of the most popular funds: Fundsmith equity (where i am a holder) and the F&C investment trust.
Hollands continues: ‘A truly diversified portfolio will include exposure to a variety of sectors, geographies and investment approaches – as well as companies of varying sizes.
‘As many as 84 per cent of the companies in the FTSE All Share index are small or medium-sized. But a tracker will allocate just 18.5 per cent of your cash to such companies, although they have been the best-performing parts of the UK market over the longer-term.’
Henderson Smaller companies trust provides exposure to companies such as Oxford Instruments, a tech company worth £1.14billion, against the $2.14trillion-valued Microsoft.
Dzmitry Lipski, head of fund research at Interactive Investor, highlights the importance of not being too reliant on certain star fund managers: ‘If you’re a fan of Terry Smith’s Fundsmith, you could look at Artemis SmartGarp Global Equity.’
This has a stake in Microsoft but also in semiconductor businesses Broadcom and Qualcomm.
The war in Ukraine has further fuelled commodity prices, making them an expensive type of alternative asset. But FTF Clear
Bridge Global infrastructure income and FP Foresight Global Real infrastructure give you access to infrastructure and also to renewables.
The view that commercial property can be an inflation hedge helps explain the 8 per cent rise this year in the Schroder Real estate trust’s shares. The trust’s portfolio does not contain failing shopping centres, but it is at a discount to its net assets of 18 per cent, an opportunity to diversify.
Here it should be said that diversification cannot entirely shelter you from storms: safe havens are not impregnable.
But you will at least have some reassurance that you have readied yourself as best you can, and taken steps to protect your nest-egg.
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