UKSA education - More Diversification

In Simple Investing you learnt about diversification - spreading your savings among a variety of assets to reduce risk. Some ways of doing this are good. Others are even better.

If you have enough money to buy two shares, and you want to diversify, it is intuitively sensible to buy two companies in different and unrelated industries. Two oil shares (Shell and BP, for example) will tend to go up and down together - responding to the same economic factors. But an oil share and a pharmaceutical (Shell and Glaxo Wellcome) will not. You could say that you get more diversification with Shell and Glaxo than you do with Shell and BP.

What does that mean?
If the outcome of one event is not affected by the outcome of another the two events are independent.

The outcomes of two coin tosses are independent ("the coin does not remember"). The price of oil and the BP share price are not. (An increase in the price of oil will improve the prospects of the owners of oil reserves).

The prices of oil and BP stock are said to be 'positively correlated'. They tend to go up and down together. You don't want this in an investment portfolio. You want investments that behave independently.

Correlation between shares
If you buy one share of Bellway (a smallish british home builder) and one share of Mcdonnell Douglas (a large american defence contractor) you have got two very different animals. The companies are of different sizes, in different businesses, based in different countries, with different global spreads. The economics of the two businesses are very different and they are likely to enjoy different triumphs and suffer different accidents. Their shares will tend to fluctuate independendently.

If you buy one share of Bellway and another share of Redrow (another smallish british builder) the reverse is the case. They are both subject to the same parameters of UK interest rates, UK housing demand and UK management, labour and social practices. You would expect the shares to some extent to track each other.

You will get more diversification with Bellway and McDonnell Douglas than you do with Bellway and Redrow. The latter are highly correlated: they tend to move about together. The former are not: they tend to move independently.

To diversify, we want shares that are uncorrelated (or as close as we can get to that). The benefits of diversification are diluted to the extent that investments are positively correlated.

How much diversification?
So it's better to have two investments than one. But how about three? five? 20? 500? The full answer to this depends on all sorts of things and requires some heavy mathematics. Luckily, you don't need a full answer, though you do have to take our answer on trust.

The benefits of diversification start to tail off rapidly as the number of investments increases. If considering shares alone, some advisers think that 10 carefully chosen shares are enough. Most advisers think that 20 are enough. It is assumed that the shares are chosen to be as uncorrelated as possible.

...and the implications for you are...
If you choose equities as an asset class you will want to compare the costs (and work) of buying 20 different shares compared with the cost (and work) of investing in a few diversified trusts or funds.

If you chose the latter route there is no point in investing in a lot of different funds to obtain more diversification. Any single general fund already has as much diversification as you want. Incidentally that's why funds of funds do not necessarily add any value to pay for their higher costs.

Conclusion
Professors have won Nobel prizes for advances in the mathematics of diversification - called Portfolio Theory. So it can be a pretty heavy subject.

But for the small investor, just stay with the idea that you need to make your bets as uncorrelated as possible and as small as possible. But not so small that you give up your returns through diseconomies of scale. And diversification should not be used as a reason for plunging into commission-laden junk.