Everyone agrees that diversification is important for managing risk. But what does diversification look like in practice?

In this article, we take a look at what counts as diversification and what doesn’t – why you can own lots of different things, and still not have a diversified portfolio.

We also illustrate the benefit of staying diversified from one year to the next.

“Invest for the long haul. Don’t get too greedy and don’t get too scared.” (Shelby M.C. Davis)

In 2021, South African investors could have made a return of 36.9% if they’d been invested in the local property index. That same year they could have made 33.1% in rands if they were invested in global property.

This was a bumper year for real estate shares, and a great time to be holding them. These were the top-performing asset classes over that period.

But just one year earlier, local property had been the worst performing asset class. If you had owned it then, you would have lost 34.5%. Which means that even the great returns of the following year wouldn’t have earned you your money back.

Similarly, if you had hung onto your global property shares after their rally in 2021, you would have lost almost everything that you made over the next 12 months. Because in 2022 global property was the worst-performing asset class for South African investors, returning -18.2%.

The rise and fall

The chart below, put together by Sentio Capital Management, illustrates just how the performance of different assets can move around from year to year. Even something like global cash, which you might think should be quite stable, can vary enormously.

In 2018, it was the best place you could have held your money. The next year, because of how currencies moved, it was the worst.

Source: Sentio Capital Management

This chart – which is often called a “smartie box” because of how the colours jump around – shows the value of diversification. You can’t anticipate which of these asset classes is going to perform better from year to year. So, the best approach you can take in order to earn steady returns is to diversify between them.

But diversification is more than just owning a lot of things. It is also not even holding a lot of different things. It is holding things that don’t behave the same way.

The right mix

For example, if you look at the smartie box again, you will see that local bonds and local cash are always quite close together. So having just those in a portfolio is not really diversifying. That’s because, most of the time, they perform in similar ways since they are both sensitive to interest rates.

Conversely, apart from 2023, local bonds and local property are usually at opposite ends of the table. Local equity and global cash also tend to move in different ways. Adding those kinds of assets together is what makes diversification work.

This idea also extends beyond just different asset classes. When you think about diversification, you need to have a number of things in mind: having a mix between asset classes; within asset classes; between different countries and regions; and between currencies.

For example, you could own a portfolio of 10 different shares on the JSE and have no diversification at all if they were all banks and insurance companies. A diversified portfolio would also hold things like retailers, mining stocks and food producers. It should also hold companies that you can’t find on the JSE, like those operating in technology, medical devices or automotive manufacturing.

You also want to make sure that you have exposure to investments in different currencies. If you look at the smartie box again, you will notice that local equities and global bonds never appear next to each other. Part of that is because of how returns from these asset classes for a South African investor vary depending on what happens to the rand.

Maintain a balance

Finally, it’s worth considering what all this diversification ends up achieving. One critical component is how it deals with risk. If you are diversified, you won’t face the yo-yo ride of what happened to local and global property between 2021 and 2023, for example.

But, also, over time, a well-diversified portfolio will capture the positive returns from those asset classes that do well and lower the losses from those that perform poorly.

If you look at the smartie box one last time, you will notice that the “Balanced” block, which represents a diversified portfolio, is never at the very top or the very bottom. From year to year, it usually finds a place somewhere around the middle. It only lost money in 2022, and that was marginal.

The beauty of that is that if you never take big losses, you never have to chase returns to try to earn them back. You can keep compounding your steady gains over time, which ultimately turn into something significant.

Over the five years from 2019 to 2023, for example, the Balanced portfolio in this smartie box might not look like it did anything spectacular. But over that full period, it was actually the second-best performer out of all these options.

That’s the power of diversification.

To discuss your portfolio, speak to us.

Disclaimer – *The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.
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