In recent years, diversification has been considered a cornerstone of investment strategy, for a good reason. By spreading assets across a range of different investment types, sectors, and geographies, an investor can mitigate risks by minimising the impact of an asset’s poor performance. But the question is, does this always work as intended?
The main argument for diversification is that it helps to reduce risk. By investing in a range of different assets, an investor can ensure their portfolio is not overly exposed to a sector, region, or type of investment. This can help to reduce the impact of market volatility and potentially protect against losses.
Yet, the returns of diversified portfolios are often dragged down by their weakest performers, limiting the potential for outperformance. For instance, in a portfolio of 10 stocks, if seven stocks perform well but three poorly, the overall portfolio returns will be affected negatively by the underperforming counters. Therefore, while diversification may help to reduce overall risk, it can also limit the potential for upside gains.
Warren Buffet terms diversification as protection against ignorance. He adds that it makes little sense if you know what you are doing. This is because the emphasis on diversification can sometimes obscure the importance of fundamental analysis and selecting high-quality investments.
Diversification without a strong understanding of the underlying fundamentals and market conditions is unlikely to generate consistent returns. Instead, a concentrated portfolio allows for a greater depth of knowledge and expertise in a smaller number of investments, and can potentially lead to better decision-making and efficient risk management.
Another argument against diversification is that it can lead to overcomplication and increased costs. This happens with many amateur investors who try to spread their eggs in as many baskets as possible.
Attempting to diversify across too many assets or sectors can lead to confusion on investment goals and strategies.
There is no one-size-fits-all approach when it comes to investment strategy. What works for one investor or pension fund may not do for another. That said, pension funds should consider a more focused and dedicated approach to portfolio construction, rather than simply assuming that diversification is always the best option.
Instead of several sub-par assets hoping they will do something, focus on finding the best investments that will grow members’ savings. This, however, does not replace risk management altogether.
The writer is a governance trainer and CEO of KenGen Staff Retirement Benefit Schemes
