Why Diversification is the Closest Thing to a Free Lunch in Investing
The reliability of investment outcomes and the relationship to performance in a diversified portfolio
The benefits of diversification is something we discuss at great length with our clients. In addition to the commonly discussed benefits of diversification: increased returns and volatility reduction; the other lost leader is the positive impact that diversification has on delivering reliable outcomes.
In a research paper by Wei Dai, PhD of Dimensional Fund Advisors, Dai identified that the most reliable drivers of expected returns, or what they call dimensions, are the premiums associated with company size, relative price and profitability. But that isn’t the end of making sound investment decisions when choosing what companies to include in a fund or which equities to include in a portfolio.
It is the pursuit of all investment advisors to achieve higher expected returns than the benchmark, though it can never be guaranteed. The best we can do is pursue outperformance by using research and data and make choices based on that information. In the end though, it is the diversification of those choices that can largely impact consistent performance outcomes.
DETERMINING THE RELIABILITY OF OUTCOMES
When a portfolio or fund achieves positive returns in a given time period, it doesn’t mean that every holding within said portfolio or fund contributed equally to the return. Some had outstanding performance and contributed a great deal, while others may have had average or poor returns.
It’s impossible to consistently predict which securities will do well and which will fall flat. Because of this, the MOST reliable way to capture higher expected returns is to have a diversified strategy with the focus on the stocks that are expected to deliver those higher returns.
In her research, Dr. Dai found that portfolios with a high degree of diversification across asset classes and region had a lower return volatility. In other words, it was easier to predict the overall outcome of the portfolio as a whole.
THE PROBABILITY OF OUTPERFORMANCE
With slightly less volatility and substantially lower tracking errors, the reliability of these simulated portfolios becomes clear and we can shift our focus then to the probability of outperformance. Comparing the different diversification levels of simulated portfolios that are targeting the same premiums, with the same expected returns and similar volatilities we see a substantial increase in the reliability of outperformance as the portfolios become more diversified.
“Over one year, a portfolio with roughly 50 names has an estimated 56% probability of outperformance. The estimated probability increases to 67% for a portfolio that holds about 500 names on average. The estimated improvement was even more significant over longer investment horizons. For example, for 10 years, with the same change in diversification level, the potential for outperformance increases from 69% to 92%.”
Based on the extensive research and findings from Dr. Dai and her colleagues at Dimensional Fund Advisors, it can be deduced that the only thing close to a “free lunch” in investing is broad diversification. What results is better reliability of the outcome of performance in a given time frame as well as better performance overall when compared with less diversified portfolios with similar premium structures. The focus of this article was on diversification across companies, but the Summit strategy takes diversification across industries and countries to further secure the reliability of outcomes and the probability of outperformance.