Diversification - the only free lunch in investing

The Nobel Prize winning economist Harry Markowitz once described diversification as an investor's 'only free lunch'. He was right, and we explain why.
5 min read

Diversification is best known by the phrase, ‘don’t put all your eggs in one basket’. And the wisdom behind this, is that if we put all our eggs in one basket, and that basket drops, all we’re left with is broken eggs.

The phrase has many applications. In business, there’s huge risks with having just one customer, because if that customer leaves, the business may fold. When applying for jobs it pays to apply for positions at many companies, rather than just one.

In investing, we should also not put all our money into just one company, because if that company fails, we’ll lose all our money.

Hence to properly diversify, investors should invest across a variety of asset classes, including stocks, cash, fixed interest, bonds, and property. Also, within a stock portfolio, investors should invest across different stocks, sectors, and geographies.

The main reason we diversify is for risk mitigation. If a fall occurs in one stock, or across a whole sector, diversification ensures our portfolio is protected. This is why it’s called a free lunch.

With stocks, there are a number of ways to obtain diversification. Firstly, we can buy into Exchange Traded Funds (ETFs) that span whole markets. Secondly, we can buy into an actively managed fund that holds a diverse range of stocks. And finally, we can own and manage our own diversified portfolio of stocks.

Broad-based ETFs

One of the best and easiest ways to diversify your investments is to buy into a low-fee broad-based ETF.

John Bogle, founder of The Vanguard Group, is credited with creating the first ever index fund. At a time when high-fee active funds were the norm, Bogle’s vision was to create a low-fee passive fund that simply tracked the index.

Mathematically, Bogle concluded that a low-fee passive fund that tracked the index, would always beat the average high-fee active fund, simply because of the fee structure. And he was right. According to Morningstar, 80% of all active US managed funds underperformed their benchmark indices in 2021, with the main reason being the high fees.

Bogle’s idea was endorsed by Warren Buffett, who said, ‘Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees’.

Active Managers

However, despite Buffett endorsing low-fee passive index funds, Buffett himself is an active investor. The reason for this is that over a lifetime of investing, Buffett has shown that he can consistently beat the market.

The aim of active managers is to beat the index, and the best ones can certainly do that.

Within active investing, there are a number of different approaches to diversification. The ‘father of investing’, Benjamin Graham believed in wide diversification, as did Walter Schloss, who would hold up to 60 stocks at a time and still generate excellent returns.

Other investors such as Warren Buffett, Mohnish Pabrai, Seth Klarman, and Howard Marks prefer their portfolios to be more concentrated. Howard Marks said, ‘I’d like to know everything about 20 companies, rather than the slightest bit about 400 companies’.

So, what is the ideal number of stocks to have in an active portfolio? There is no hard and fast rule, but it is generally accepted that a range of 20 to 30 stocks is reasonable.

Going Global

One of the great features of today’s suite of ETFs, is that they enable an investor to invest into share markets around the world.

In Australia one can buy ETFs based on the ASX 200, that provides a simple way to own a piece of corporate Australia. And in a similar way, ETFs are available for the stock markets of other countries, as well as stocks that span the globe. This can give investors exposure to some of the biggest companies in the world, such as Apple, Microsoft and Nestle.

Diversification provides enormous benefits to investors. Firstly, as a risk management tool, but also to give an investor exposure to some of the best companies at home and abroad. All in all, that makes diversification a truly free lunch. Bon Appetit!

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