You hear it so often. Most financial advisors encourage investors to diversify their investment portfolios. Why the need to diversify in the first place? And does diversification really work?

Diversification involves splitting your money up so that it can be invested in several different areas. It means not putting all your eggs in one basket. While diversification lowers risk, it can lead to money going into investments that either lose money or deliver low returns.

Thus some investors question the need to diversify in the first place. They point out that if all their money was placed into one great investment, then they would achieve the maximum amount of returns. But that's with the benefit of hindsight. In reality, it is much harder to accurately predict which investments will deliver huge profits in the future.

Given this uncertainty, some investors prefer to put all their money into fixed deposits. Others might bet the entire farm on just one investment. Both methods are not very good. The latter is akin to betting, while the former means passing up on good investment opportunities. The benefit of diversification is that it gives you a wider exposure to various investments while lowering risk.

WE SET OUT A SIMPLE HYPOTHETICAL EXAMPLE BELOW

We have 5 possible investments, labeled A,B,C,D,E. At this point in time, each of these investments look as if they might deliver good returns. But we do not know for sure. For investors who choose to avoid all 5 investments and put the money into fixed deposits, they would be passing up several potentially good investment opportunities. For investors who decide to put all their money into just one of these investments, mathematically their chances of making it big is around 1 in 5, or just 20% (20% is not exactly very good odds, and since gambling usually involves even worse odds, I still fail to understand why people want to gamble).

However, let's diversify. We split our money into 5 equal portions and invested them into the 5 investments A,B,C,D,E. Our investments looked like this:

Investment A	Investment B	Investment C	Investment D	Investment E
$5,000	$5,000	$5,000	$5,000	$5,000

Now, let's assume these investments were left untouched for 20 years.

After 20 years, the 5 investments had the following annualised returns:

Investment A	Investment B	Investment C	Investment D	Investment E
+15% per year	+5% per year	0% per year	-5% per year	-15% per year

At this point in time (after the 20 year holding period) how much money do you think you'd have?

Looking at the above return, how many of you are thinking that the exercise was a total waste of time because after 20 years, you're back where you started with the original $25,000?

It may surprise you that the actual amount of your total investments after 20 years based on the above, is $102,085

That's 4 times higher than what you started out with, and your portfolio has now effectively delivered an annualised return of 7.29% each year on average. How did that happen? How could the above portfolio deliver such a good return when there should have been no gain at all? Let's look at Table 1 for an explanation.

TABLE 1

Year	Fund A	Fund B	Fund C	Fund D	Fund E	Total
Starting amt	$5,000	$5,000	$5,000	$5,000	$5,000	$25,000
2004	$5,750	$5,250	$5,000	$4,750	$4,250	$25,000
2005	$6,613	$5,513	$5,000	$4,513	$3,613	$25,250
2006	$7,604	$5,788	$5,000	$4,287	$3,071	$25,750
2007	$8,745	$6,078	$5,000	$4,073	$2,610	$26,505
2008	$10,057	$6,381	$5,000	$3,869	$2,219	$27,526
2009	$11,565	$6,700	$5,000	$3,675	$1,886	$28,827
2010	$13,300	$7,036	$5,000	$3,492	$1,603	$30,430
2011	$15,295	$7,387	$5,000	$3,317	$1,362	$32,362
2012	$17,589	$7,757	$5,000	$3,151	$1,158	$34,655
2013	$20,228	$8,144	$5,000	$2,994	$984	$37,350
2014	$23,262	$8,522	$5,000	$2,844	$837	$40,494
2015	$26,751	$8,979	$5,000	$2,702	$711	$44,144
2016	$30,764	$9,428	$5,000	$2,567	$605	$48,363
2017	$35,379	$9,900	$5,000	$2,438	$514	$53,230
2018	$40,685	$10,395	$5,000	$2,316	$437	$58,833
2019	$46,788	$10,914	$5,000	$2,201	$371	$65,274
2020	$53,806	$11,460	$5,000	$2,091	$316	$72,673
2021	$61,877	$12,033	$5,000	$1,986	$268	$81,165
2022	$71,159	$12,635	$5,000	$1,887	$228	$90,908
2023	$81,833	$13,266	$5,000	$1,792	$194	$102,085
Annualised returns	+15%	+5%	0%	-5%	-15%	+7.3%

We see that in the first year, the portfolio did deliver exactly zero returns. However, as the years continued to go by, the worst performing investment became a smaller part of the total portfolio, while the best performing investment became a bigger part of the portfolio. Eventually the compounded returns of the winning investment A, (and to a lesser extent B) helped the portfolio to deliver good overall returns.

This highlights both the power of compounding as well as the power of diversification. On seeing the individual returns, some might think that the investments chosen for the above example were terrible. Two out of the 5 investments lost money consistently! And investment C is like putting money into your savings account. After 20 years, you might as well have not bothered. (A $5,000 "investment" into a savings accounts giving 0.5% per year results in just $5,524 after 20 years).

Even investment B was not that great. It returned 5% per year, nothing to be particularly excited about. Only investment A was the true winner, delivering a compounded 15% per year. However, the power of diversification has allowed the investor to get an annualised portfolio return of 7.3%. Thus when you diversify, you do not require all your investments to make it big, you just need some of them to succeed.

This is what fund managers attempt to do with their stock selection, and this is also why we advise investors to diversify. In the above example, diversification allowed us to be almost completely certain that we would get a good return for our portfolio, even if two of the selected investments went nowhere, and one was the equivalent of putting your money under the mattress!

In the real world, it is also unlikely that an investor will end up with an investment that consistently loses money every single year for 20 years. He would most likely have switched out from this investment long before the 20 years was up. It is also not easy to get an investment that delivers an annualised 15% over 20 years.

Nevertheless, the above example was meant to highlight to investors the concept of diversification and to show in raw numbers why it works. Through this example, we hope that investors realize why diversification is very important. It allows you to invest with greater confidence as all your investments need not be huge winners for you to obtain a good overall return for your portfolio.

---