Most investors fail to beat the market consistently. There are several reasons for this, including ‘short-termism’, market index following and herd behaviour.
Another fault is a tendency to own too many shares – a strategy I call ‘diversification to the point of mediocrity’.
People often use diversification to reduce risk. If you invest in many different companies, your total portfolio won’t get badly hurt if one of those company’s shares suddenly plummet. On the other hand, a share that rockets up won’t have much impact on your total net worth.
In his 1952 study on investment portfolio construction and performance, Nobel Prize-winning economist Harry Markowitz brought to light what now seems totally obvious – above average returns can only flow from above average risk. Risk in this context is defined as share price volatility. Some shares are clearly “riskier” than others. And not only can risk be measured for a share, but also an entire portfolio.
Surprisingly, however, Markowitz also found a relatively low risk portfolio can be constructed using mainly risky shares. You might think the only way to reduce the risk of your share portfolio is to include stable, low volatility shares to offset high-risk selections. Not so!
Two shares may be very risky but tend to move in opposite directions under the same conditions. The fall in one is then offset by the rise in the other. Such shares are said to display a low covariance. Conversely, shares or groups of shares that move together are said to have a high covariance. In fact, a portfolio of individually risky shares might be deemed conservative if made up of shares with low covariance.
An example is a portfolio that includes oil company shares and shipping company shares.
When oil prices are high, the oil company’s profits will rise, and its share price will most likely go up. But the cost of oil is a major operating expense in transportation, so profits and market price for the shipping company will fall. Conversely, in the years when the oil price is low, profits in the oil company will fall, while for the shipping company, profits will rise.
In a New Zealand context, two companies that might balance each other if the dollar were to rise suddenly, for example, would be Fonterra (FCG) and Sky Network TV (SKY).
As an exporter, the value of Fonterra’s sales overseas would be worth less in local terms if the dollar went up, while Sky, which spends a lot on imported TV programmes, would see a positive impact on its bottom line.
So, while diversifying your share investment portfolio can be a good way to maximise the expected return for a given level of risk, remember the composition of shares is important. Diversify, sure, but not too much, and make sure your portfolio includes shares in sectors likely to go up – or at least hold their value – in circumstances where others in your portfolio would likely go down.