OLD ARTICLE – Original posted on April 7, 2016
The global economy is desynchronised with significantly diverging views at both global and country-level. China could implode, Europe could fragment and USA could falter. All of these could happen. And then you get commodity volatility coupled with massive forex swings (up and down)….
If you listen to a hundred economists views on how the world will play out over the next decade, you will probably get a hundred and one different answers regarding this.
While the future is always hard to tell, we are at a significantly murky point in the financial history of civilisation and forecast risk is definitely elevated.
(As a side note, where we are in history currently looks quite similar to the “Long Depression“, but not quite the same… Worth reading this. Terry Smith actually pointed this out to me, and I am starting to agree with him.)
Somehow amidst all of this, everyone appears to have forgotten about diversification. Why? Well, that is actually quite simple to explain.
The last half decade has been one dominated by falling interest rates and large stimulus packages driving the same stocks and asset classes upwards. When the same things keep happening, the same investments keep generating returns and, when this happens over almost a decade, then human bias tends to forget that it can ever be any other way.
This had led to complacency and overly concentrated portfolios (not in terms of individual investments, but in terms of “concentrated themes”). These portfolios look great when the one or two key variables that they are exposed to work (i.e. falling interest rates, growing China and QE packages), but the opposite is true also.
Let me phrase it this way, when you look at a large fund managers portfolio and find that he has most of the large resources companies in it. He is not in fact stock picking, rather he is sector picking and just making sure that he diversifies his exposure within that specific sector.
This is typical of bigger funds that have massive liquidity constraints, but it need not be so of the rest of us.
Don’t know where the macro will go? Unsure on South Africa’s future? Not sure if the dollar will strengthen or weaken? Wondering about Europe, Brexit and China?
Why not just find the best stocks that lie all over the place, make sure you select a weighting where each exposure helps you sleep at night, and go on with your life. The trick is to make sure that there is as little overlap as possible in the exposures (obvious or unobvious overlap).
For example, say you hold one of my favourites: AdaptIT (ADI). Well, then make sure you do not hold Illovo (ILV), as ILV is one of AdaptIT’s biggest clients, even though they operate in different sectors.
Another example is, Datatec (DTC). Going with the tech theme, Datatec is a hardware distribution business of global scale that predominantly (but not exclusively) distributes Cisco. If you hold this, make sure you do not hold either Cisco or Pinnnacle (PNC). The former is an obvious overlap, while the latter is the same business model, much smaller and domestic. If Datatec can’t do well, then it is highly unlikely that either Pinnacle or Cisco will be doing well.
Finally, another example, don’t hold every gold stock that exists out there. Rather, after careful research and consideration, pick one and hold it. That is, if you are comfortable with gold mining stock exposure. If you are not, then don’t hold any. There are tons of different assets out there, you need not hold all of them in order to achieve a degree of diversification.
Ultimately, the art of fund management is quite simple: find uncorrelated asset that will generate good investment returns, and hold just enough of them that your portfolio’s return is protected from any single one of them.
So in this world of growing uncertainty, don’t forget about diversification. It’s boring, but it’s useful.
P.S. I believe you should never add an investment based purely on its ability to add diversification. The starting point should be whether or not the investment is good as a standalone investment. If it is not, do not look further. If it is, then only consider if it adds to your portfolio’s diversification or detracts from it…