Protecting portfolios against the crisis: Instruments of 'mass diversification'
The benefits of a broader approach to portfolio management
In a world where Covid-19 is tearing through stockmarket valuations, IPO returns are floundering, developed and emerging markets are diverging, and US Treasury yields are collapsing, the risk of being overexposed to one area of the market has become stark.
Harbingers of doom will say these are all signs of an imminent, global recession. Regardless of whether this is indeed the case, the importance of portfolio diversification has once again become strikingly clear.
A world of change
Even before the coronavirus effect there have been several significant disruptions to markets of late.
After being seen as a path to guaranteed riches for so many years, the power of IPOs has been challenged. One high profile example is co-working company WeWork, which faced intense scrutiny over its path to profitability and its leadership after publicly filing its IPO paperwork in August.
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This culminated in the exit of its CEO, the downgrading of its valuation $47bn to as low as $10bn within a month, and - ultimately - the shelving of IPO plans.
Meanwhile, while taxi firms Uber and Lyft were able to get their IPOs launched, they currently sit well below their listing price.
This issue is sector-wide, and the underperformance of newly-listed firms hits levels not seen since the Global Financial Crisis.
Alongside this, 2019 saw swathes of high-flying shares slow after years of dominance - Tesla and Netflix fell by 30% over the year - while long duration US Treasury yields reduced by 50% over the period.
To cap it off, the divergence between developed and emerging markets has been striking, with investors opting for the safety of the former in the hope of shielding themselves from a recession.
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These factors demonstrate the risks to investors of relying too heavily on one particular area - be it an asset class, a region, a sector, or a stock.
The trends that may make any one of these attractive at a particular time are always moving and are more than capable of reversing.
The destruction of portfolio value does not necessarily require a catastrophic loss. All that is needed is a correlated decline in the amount of several components to which an investor has over-exposed themselves.
Given our tendencies to invest with our hearts - buying into stories rather than facts - this is not uncommon at all.
Diversification - reducing idiosyncratic risk while maintaining risk premium
It is for this reason that diversification of a portfolio across a broad spread of asset classes, regions, sectors and stocks is so critical.
An investor who allocated all of their savings to Netflix in January 2019, is likely to be sitting on a much more significant loss than one who invested half of their savings into the stock and the rest into uncorrelated stocks.
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The S&P 500 was able to remain just shy of its all-time high last month despite various high-profile stock horror stories throughout the year.
Spreading wealth across the market reduces the impact of idiosyncratic risk present in individual assets.
Not only does this reduce overall portfolio volatility, resulting in an improved risk/reward outcome, but it also cuts the chance that an investor will sell at what often turns out to be precisely the wrong time.
The same logic applies on the flip side, as well. Research shows that the degree of risk reduction in a portfolio lessens as more stocks are added before flatlining at about 25 holdings.
But this does not mean that investing in any assets beyond this is 'over-diversification'. In fact, as an investor's holdings continue to increase, so too do their potential sources of risk premium.
Let's look at an example. An investor who put $100 into the S&P 100 on 1 January 2000 would have been sitting on $277 by the end of 2019.
Over the same period, another who put $100 into the S&P 500 would have been sitting on $324 - a significantly better performance.
By spreading money across a much broader pool of stocks, the S&P 500 investor was exposed to all of the names that vastly outperformed over the 19 years.
The power of this exposure should not be under-estimated; Netflix rose by 33,178% between its initial listing and the end of Q1 2019, and there are many other success stories in the same vein.
For the S&P 100 investor, exposure to this ultra-high growth was limited by a restriction to the US's very largest stocks, which do not usually enjoy such high growth.
A world of opportunity
The power of mass-diversification is evident - it not only reduces single stock risk, but also ensures that investors do not miss out on excellent investments.
With instruments such as ETFs and index funds now dominating the market, it is easier than ever for investors to forego the risks inherent in stock punts in favour of low-cost exposure to a whole world of investments.
Mark Northway is an investment manager at Sparrows Capital
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