By George Carter*
When it comes to defining the merits of diversification, I’m firmly with Harry (Markowitz). He famously called it “the only free lunch in finance” – a means of reducing risk without sacrificing returns.
But while this puts me in the same camp as a Nobel Prize winner, it would contemporaneously seem to pit me in direct opposition to not just one of the world’s most renowned and successful investors, but also the most revered British economist of the 20th century.
Warren Buffet dismisses diversification as “a protection against ignorance”, whilst in the lofty tones of mid-20th century England, John Maynard Keynes has described it thus:
“To suppose that safety-first consists in having a small gamble in a large number of different companies where I have no information to reach a good judgment, as compared with a substantial stake in a company where one's information is adequate, strikes me as a travesty of investment policy.”
An equally compelling argument, but also a reminder that all diversified portfolios are not created, or managed, equally. Because it seems to me that these criticisms of diversification are pointed towards a strategy of buying shares not in a considered selection of companies, but in a miscellany of which you have little knowledge. Of flying blind. Or to reframe it slightly, of passive investment.
Take, for example, the imminent inclusion of Tesla in the S&P 500 and what this will mean for the reallocation of passive funds. Wall Street analysts are estimating that up to $100 billion of investments will need to be sold, totally irrespective of price or valuation, “to make a hole big enough to fit purchases of Tesla shares.” Passive investors will therefore find themselves powerless and beholden to a huge round of selling and buying of shares for no other reason than an indexing decision by a committee that is unaccountable to those very investors.
I’m not commenting here on whether buying Tesla at these prices is right or wrong. Rather I’m noting, to echo Maynard Keynes, that allocating capital in a way which takes no consideration at all of the value of what’s being bought or sold could easily be viewed as “a travesty of investment policy”.
Active vs passive diversification is an especially pertinent consideration here in New Zealand when it comes to KiwiSaver, where your allocation of funds is wholly constrained by the products and chosen exposures of a single provider. And the choice is not that wide to start with. Indeed, when you consider that the scheme is available to every New Zealander, one of the most, or perhaps least, remarkable things about the scheme is the similitude of the products available.
The most appropriate investment strategy for someone picking up their first pay packet with an immediate goal of home ownership will be poles apart from that of someone preparing to pick up their last and enter into retirement. Yet the enormous breadth between these two situations, and the myriad of circumstances that exist in between and either side, means that good diversification can look quite different depending on your stage in life.
In an era of low interest rates and ever lower expected returns, I expect non-traditional sources of return and differentiated strategies to play an increasingly important role in good portfolio diversification - which was partly the reason we recently introduced the ARK Disruptive Innovation Fund into our KiwiSaver Scheme. But however you choose to do it, and whatever stage of your investment life you are at, ensuring your KiwiSaver portfolio is well diversified in a way that suits your investment goals should be integral to your investment considerations.
*George Carter is managing director of Nikko AM NZ.