Rethinking Diversification


In the investing world, diversification is a concept that has been ingrained in investors’ minds for generations. Sometimes hailed as the one “free lunch” in investing, it has become an oversimplified term for many investors, often meaning nothing more than “don’t put all your eggs in one basket”.

Unfortunately, we have seen many fundamental portfolio mistakes made in the name of diversification. A more nuanced understanding of this concept would be helpful, and we hope that exploring it will help you re-evaluate the makeup of your investment portfolio.

In the following article, we will return to first principles and re-examine the true definition of this core principle. This will help you harness its power to align your investments with your unique financial goals.

Owning A Bit of Everything

Nick Murray, a famous coach to financial advisers, eloquently states that diversification means that you will “never own enough of any one sector/idea to make a killing in it, nor enough to get killed by it.”

Many investors, wanting to avoid risking their future financial independence on a concentrated portfolio bet, have sought to achieve this risk reduction by owning an array of asset classes. As a result, many portfolios include not only the common asset classes of equities (The Great Companies of the World), bonds, and cash but also more esoteric asset classes such as precious metals, real estate schemes, infrastructure projects, venture capital, and a host of other investments classified as “alternatives”.

While there may be reasons for owning these asset classes for other reasons, we believe investors should carefully consider whether these assets are worth owning for “diversification”.

The portfolios we encounter can often be described as a “mess.” Due to the indiscriminate spreading of money across asset classes, it can be difficult to fully understand what was initially intended for the portfolio and what it can be expected to achieve in the future. We often see an overlapping of market exposure, higher and opaque fees, and correlations between asset classes that aren’t well understood.

We do not think this is what diversification means, and we do not see evidence that it reliably helps investors achieve their desired outcome: to achieve and maintain financial independence.

Redefining Diversification

A more technical definition of diversification is “owning a wide variety of investments with different characteristics”.

This principle can be implemented by first considering which asset classes will help an investor reach financial independence over the long term. In our view, equities, cash, and bonds are the only asset classes investors require outside of residential property (for most investors, the house they live in).

By carefully planning for your unique goals and circumstances, the above asset classes can be combined to give you the best chance of financial success. Once this asset class mix has been decided, diversification becomes the discipline of spreading your risks within each asset class. Rather than owning all the asset classes, diversification means owning many assets within the few asset classes suitable for your situation.

While this approach may seem straightforward, we have witnessed how it fosters a clear focus on the more essential aspects of financial planning: what you are planning for, what contributions are required, what good investor behaviour looks like, and the importance of remaining patient during different market cycles.

Many Eggs in the Right Baskets

Diversification is a powerful tool, but it’s essential to understand its true meaning. Rather than mindlessly owning many asset classes, aligning your investments with your unique objectives is vital.

The right basket for creating real long-term wealth is investing in the great companies we use daily, the asset class known as global equities. We believe in spreading your eggs within this basket by owning thousands of these companies. This is true diversification.

Is your portfolio aligned with your goals, or have you fallen into the trap of over-diversification? By asking yourself this question and making the necessary adjustments, you can unlock the true potential of diversification and set yourself on the path to financial success.