This article was published on 12 June 2007. Some information may be out of date.

Riding to the rescue of diversification

Diversification — a key element to successful investing for most people — has taken a bashing in the press lately. Even David McEwen, who writes this column alternately with me, quoted criticism of diversification on this page a few weeks ago. I feel bound to leap in and defend it.

As you probably know, diversification is about spreading your money over lots of different investments. It works particularly well with shares.

The obvious advantage is that good performance by some investments can offset bad performance by others.

But there’s more to it. If the expected average annual return on shares over the next decade is, say, 10 per cent, you would expect that same return on a single share or on 100 shares.

Yet if you own 100 shares there’s much less chance that you will lose lots. You have reduced your risk without reducing your expected return. It’s been called “the only free lunch in investment”.

Not everyone likes diversification, though. Let’s start with McEwen, whose list of Swiss investment principles included:

“Resist the allure of diversification. The more you diversify, the smaller your investments get and the wins will only cancel out the losses. Also, you become a juggler, liable to lose control of the balls. A little diversity won’t harm, but no more than about six items. “

Next, journalist Maria Scott says of NZ Shareholders Association chairman Bruce Sheppard, “He does not think that a wide spread of investments necessarily reduces risk; the more shares you hold, he argues, the less you will know about the companies.”

Finally, an article by journalist Diana Clement titled “I must (not) diversify” quotes hugely successful share investor Warren Buffett: “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”

Clement goes on to say that Jeff Mathews of Spicers Wealth Management says few people, if any, get rich by spreading $1 million across 100 different investments.

“Such a spread tends to bring back returns that track the overall performance of a market, and you may as well own a low-charging exchange-traded fund that simply tracks the index,” says Clement.

She also quotes Matthews as saying that many of his wealthiest clients became so with “concentrated bets on one business”, their own.

It’s quite true that people who diversify won’t do as well as those who put their eggs in one basket that turns out to be a big winner. But what about the people Matthews doesn’t see — those who concentrated on one basket that failed?

I also reject the Swiss idea that, if you diversify, the wins will only cancel the losses. The value of most investments rises over time. If you diversify, over ten years or more you are highly likely to do well.

One theme that comes through most of the comments is that those who spread their money around many investments can’t know much about them, and that it’s better to go with a smaller number that you know well.

That seems hard to argue with. But I have two reservations:

  • Most people don’t want to put much time or effort into investing.
  • Even those who do won’t necessarily prosper. With most shares, to beat the market you have to know more than the big financial institutions. That’s a tall order.

Many people who think they are good at picking shares would do just as well with Clement’s “low-charging exchange-traded fund that simply tracks the index”.

And they might as well go that route. Diversified index funds have done just fine over the years — for much less work. That’s good enough for me.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.