When does diversification go wrong?

Diversification - too much is just right

“Diversification: the only free lunch in the financial sector” may be a cliché, but it contains more than a grain of truth: In a world in which it is difficult to forecast returns, a reduction in volatility does not come at the expense of returns , extremely valuable.

A distinction must be made between diversification and protection. With diversification, it is expected that all ideas generate a positive return, while with hedging, ideas are consciously implemented that balance each other out in terms of risk and return. We are interested in real diversification: good investment ideas that are barely correlated with one another.

Investors do not always appreciate this approach, as they fear that diversification will reduce volatility, and on the basis of naive analyzes, for example of the information ratio, conclude that this inevitably also reduces the potential return. This conclusion is based on the incorrect assumption that market returns are distributed independently and identically over time (the abbreviation i.i.d. is used for this in statistics).

We know that returns in the real world show different trends and that investment ideas can therefore be negatively correlated with one another and still generate positive returns. A good example of this is the development of US Treasuries and the S & P500 over the past 20 years. Both are negatively correlated with each other in most periods, but each generated significant positive returns over the entire period under review.

Fig. 1: Assets that are negatively correlated with one another can generate both returns
Source: Bloomberg as of May 8, 2020. Past performance is no guarantee of future performance.

Although the advantages of diversification seem obvious, the danger of “overdiversification” is spoken of again and again. There are three main possible reasons for investors' skepticism about the benefits of true diversification:

  • An idea that contributes to diversification in a certain environment can no longer have a diversifying effect if the correlations change - which can be observed over and over again. An example of this could be structured products with a high coupon yield but an inherent tail risk, i.e. extreme risk. The coupon payments mostly do not seem to be correlated with the overall market and are only caught in the same downward pull as other risky investments in an extreme event.
  • Investors, who mostly deal with very limited investment universes, may have doubts about the potential for real diversification. For example, the possible degree of diversification of a long-only equity portfolio will be significantly more limited than that of a long / short multi-asset portfolio.
  • Hindsight bias. Diversification is good - but it's even better to have bought the asset that performed best! That is, of course, a weak point. However, it is implicit in much of the criticism of diversified portfolios. It is in the nature of things that some of the investment ideas will have lost value over the period under review. Since there are only limited predictions that can be made, that does not necessarily mean that sticking to these ideas was not a good idea.

True diversification is undoubtedly beneficial, but also difficult to achieve, as identifying genuinely independent sources of return is very laborious. In addition to diversification, it is of course also important that the ideas generate a positive return.

We start with what we think are good ideas and then look at how we can diversify rather than just looking for diversifying, but not necessarily good, ideas. Since the additional benefit from the inclusion of further independent sources of return gradually diminishes, it is reasonable to assume that there is a “sweet spot” - an optimal point at which diversification is sufficient to benefit from the advantages, but no additional costs or costs . additional work is incurred for the mapping of further diversifying investments.

Fig. 2: Diversification benefits are not linear
Source: Invesco, as of June 30, 2020. For illustration only.

At this point, however, another very important market insight comes into play: the finding that diversification always decreases in a crisis. In times of crisis it inevitably shows that part of the supposed diversification in a portfolio was not sustainable, as some of the returns turned out to be not really independent.

“In the crisis, the correlation factor tends towards 1,” it is often said. However, the reality is a little different: Diversification is always decreasing, but is not being completely canceled. Figure 3 illustrates the long-term development of the effective number of independent positions in a specific multi-asset universe.

Fig. 3: More independent factors contribute to diversification
Source: Invesco, as of June 30, 2020. For illustration only. Can change. Past performance (simulated or actual) is no guarantee of future developments.

The illustrative Global Balanced 60/40 portfolio consists of 60% global stocks and 40% global bonds. Diversified growth funds are modeled as broad portfolios of selected equity, corporate and government bonds as well as currency positions (long only). Unrestricted multi-asset portfolios can take (long, short and relative value) positions in different regions and asset classes. A principal component analysis was carried out to determine the independent factors in order to explain the variance in the returns of the portfolio positions as statistically uncorrelated factors. The distribution of these factors has been summarized in a single numerical statistic. This statistic corresponds to the number of equally weighted, uncorrelated factors in the portfolio. All data was simulated using indicative portfolios and historical investment returns. From the knowledge that diversification presumably decreases precisely when we need it most urgently, and that reduced diversification has a non-linear effect, one can conclude something very important: In order to build a really robust portfolio, it seems advisable to use in good times to have “too high” diversification in order to still have a sufficiently diversified portfolio when you really need it. This can be illustrated using two starting points:

  • "Sufficient" diversification: The investor benefits from most of the advantages of volatility reduction without investing too much effort in an even broader risk diversification - illustrated using 4 factors that offer a diversification advantage of 50%.
  • "Too high" diversification: an additional diversification from which few additional advantages seem to result - illustrated by ten factors that only have an additional diversification advantage of 28% for (at least) 2.5 times as much effort in generating ideas deliver.

However, if there is a crisis situation in which diversification declines, the advantages become clear: a higher initial diversification serves as a buffer through which the "turning point", which is reached with a smaller number of independent factors, is avoided and the volatility remains limited .

In this example, two of the factors were found to be non-independent, reducing the number of independent factors by 2. This increases the volatility of the red portfolio to 41%, while the volatility of the green portfolio only increases by 12%.

Fig. 4: Diversification advantages in the crisis
Source: Invesco, as of June 30, 2020. For illustration only.

This simplified example makes an important point clear: real diversification serves as a buffer and basis for building a much more robust portfolio - and thus greater stability of the capital investment.

This philosophy is at the core of our portfolio construction process. It is implemented with a combination of quantitative methods (comprehensive use of hypothetical scenario analyzes and traditional risk models) and qualitative discretionary decisions (e.g. on the fundamental return drivers of individual investment ideas or the behavior of market participants). Both are essential to achieve absolute returns under different market conditions.

Learn more about the strategy