Spread it around: Buying into the wisdom of diversification works

Six stocks and a toe in another asset class can help you to avoid losing your hard-earned capital

Stock picking: the rational for diversifying stock allocations is well understood as firms change shape, industries die off and new ones emerge. photograph: andrew burton/getty images

Stock picking: the rational for diversifying stock allocations is well understood as firms change shape, industries die off and new ones emerge. photograph: andrew burton/getty images

Tue, Jan 21, 2014, 01:10

Diversifying in stock markets is a time-honoured rule for survival and the following example makes for a simple but quite powerful message.

I introduced this message into my own investment training seminars after a colleague of mine, Dermot Walsh of Davy, first suggested it.

The rational for diversification is well understood. Businesses change shape, industries die off, new ones emerge. Business is dynamic and ever-changing – and the risks change over time.

The table (below, far right) highlights the performance of a portfolio of just six holdings from the peak in the Irish equity market on February 1st, 2007 through the 82 per cent slump by mid-March 2009 to the close of business on December 31st, 2013. Allied Irish Banks went bust and is effectively down 100per cent, but the performance of the overall portfolio is up 33.6per cent, excluding dividend income. In Ryanair’s case, dividend income was significant as the group paid a few special dividends over the period.

Owning the banks in Ireland through the global credit crisis was a catastrophe.

Had you spread your monies across six different holdings ensuring sector diversification and just one alternative asset class (gold), however, you would have survived the worst bear market in 70 years.

The table (below) makes the same point in a more dramatic way. Owning just one stock, a bank, resulted in a 100 per cent loss. There’s no recovering from that.

By adding in CRH, which is down 35 per cent since February 1st, 2007, the combined holdings have resulted in a loss of 67 per cent.

Adding in a third stock, DCC, reduces the portfolio loss to 16 per cent. Inclusion of a fourth stock, Kerry, swings the portfolio into profit with a gain of 26 per cent. A fifth stock, Ryanair, makes little difference. But adding in one other asset class, gold, brings the gain to just short of 34 per cent.

So just six holdings across different sectors of business and one alternative asset class moved an investor from a 100per cent loss to a 34 per cent gain.

I think the benefits of diversification, in terms of avoiding the risks of a total loss of capital, are well made with this simple example of a six-stock portfolio.

The chart (right) makes a separate point. Following a severe setback, it often takes time for markets to recover. Diversification may not appear to assist you in the teeth of the downturn.

Gradual recovery
But as the economic crisis passes and corporate earnings and economies start to recover, companies that were not mortally wounded by too much debt or extreme overvaluation at the outset start a gradual recovery.

Indeed, in the case of DCC, Kerry and gold, prices have gone on to new all-time highs. Near the bottom of the market in February 2009, the value of a €10,000 investment in such a portfolio had declined 34 per cent.

Losses were greater in the stocks but a positive performance by gold kept the losses to 34 per cent.

It wasn’t until February 2012 that the overall portfolio was back in positive territory, with a 7 per cent gain. By the end of last year, the portfolio had gained 34 per cent excluding dividend income.

It’s not volatility in markets we must avoid, it is the risks of a permanent loss. Poor business models, too much debt (which sank the banks) and overvaluation of a business or asset is what leads to a permanent loss.

More times than not, stock markets recover fast from downturns and move on to new highs.

Rory Gillen runs the online investment newsletter, GillenMarkets.com and is author of 3 Steps to Investment Success.

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