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Odds on diversification

Do not apply the rules of a game of chance to your approach to portfolio management. David McFadzean explains how you can spread the risks through diversification.
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Published 2 January
3 mins

Let’s start by tossing a coin. Assume you have £100,000 in savings. The bet is: heads, I give you another £100,000 and you’ve doubled your money; tails, you give me your £100,000 and you’re left with nothing. The coin is fair and each outcome has a 50% chance – would you take the bet?


If you say no, you would definitely be in the majority. Most of us feel the pain of losses much more than we savour the joy of gains, so even a completely fair 50/50 bet seems too much of a risk. Especially with money we have worked hard to earn and has taken a long time to accumulate.


So how can I make the bet more palatable? What if I toss 100 coins (all at once) and you are betting £1,000 of your £100,000 savings on each coin. In theory it’s still possible that every coin comes up tails and you lose all of your savings, but of course the most likely outcome is that 50 of the coins land heads, the other 50 land tails and you are left where you started with £100,000.


You also now have a 46% chance of being up on the bet (51 or more heads) and more than an 18% chance of being at least £10,000 ahead (55 or more heads.)


More importantly, the chances of 60 or more of the coins landing as tails (you lose) is less than 3%, which means you would have to be very unlucky to lose £20,000 or more.


(Finally, for the statistically minded, your chances of losing everything have gone from 50% to something in the order of 7.889 x 10-31, a vanishingly small number.)


It all starts to sound much more reasonable. In any venture involving uncertain results, diversifying across a range of ‘investments’ drastically reduces the probability of extreme outcomes and makes participation a much more comfortable experience. Put simply – diversification reduces risk, even when there is only one game in town.


In the real world of portfolio management, where the risks are not usually 50/50 and there is a huge range of potential investments, there are even more opportunities to diversify and even more benefits from doing so. A good portfolio manager will take advantage of the following:

  1. Spreading your investments across a range of different asset classes. This will normally include cash, bonds, equities, property and alternative investments.  Each of these asset classes will behave differently according to different market conditions – it is very unlikely they will all perform poorly at the same time.
  2. Spreading your investments across a range of countries – by investing globally, and not just in your home country, your portfolio will be exposed to different stages of the economic cycle. This will also help dampen the effect of any economic or political issue affecting a particular country or region.
  3. Spreading your investment across a range of industry sectors. Similar to countries, different sectors of the economy react differently to economic events.  For example, a rise in interest rates may be good for banks, but bad for industrial companies who need to borrow to invest in equipment or other manufacturing capacity.
  4. Spreading your investments across a range of different fund managers. Some fund managers are experts in global equities, others are experts in UK bonds or emerging market debt.  Not only will your portfolio benefit from experts in their particular field, but each of these fund managers will have different economic and valuation models which will have greater or lesser success at different times.

Finally, don’t forget that, unlike tossing a coin, portfolio management is not a game of chance. Yes, investments can go down as well as up, but a professional wealth manager should be able to demonstrate they can deliver consistent results over a long period with a greater success rate than 50%. Does yours?

Clients of Nedbank Private Wealth can get in touch with their private banker directly to understand how their portfolios are responding to market events, or call +44 (0)1624 645000 to speak to our client services team.

 

If you would like to find out more about how we can help you manage your investments, please contact us on the same number as above, or complete the contact us form using the link below.

Investments can go down, as well as up, to the extent that you might get back less than the total you originally invested. Exchange rates also impact the value of your investments. Past performance is no guide to future returns. Any individual investment or security mentioned may be included in clients’
portfolios. They are referred to for information only and are not intended as a recommendation, not least as they may not be suitable. You should always seek professional advice before making any investment decisions.

about the author

David McFadzean

David McFadzean

David is responsible for spearheading the growth of our wealth management business across the company’s international jurisdictions. Prior to taking on his current role, David was integral in developing the bank’s investment proposition for high-net-worth individuals, trustees and investment consultants. He is also a member of the bank’s executive committee.

 

He has over 25 years’ experience working for global blue-chip companies in both London and Jersey, and providing investment solutions to a wide variety of clients around the world. Prior to joining Nedbank Private Wealth, David spent 15 years with RBC Wealth Management where he held several senior roles, latterly leading the investment business as managing director and head of discretionary investments in Jersey.

 

David is a Chartered Fellow of the Chartered Institute for Securities & Investment and a Chartered Wealth Manager. 

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