Unraveling Risk From Diversification

For more than thirty years market commentators and academics have taught investors to diversify their portfolios to avoid risk - investors have been bombarded with the notion that broad diversification is the only sensible way to invest.

When the GFC struck, these diversified portfolios were dealt a punishing blow as all markets plunged and the strategies that were meant to protect investors lay discredited.

All the catch cries and clichés about international diversification, property as a safe haven, hedge funds making money in any market, provided little comfort as none of these strategies provided any genuine protection.

Since the GFC, investment markets have been very volatile and have continued to test investors patience. 2011 proved one of the most volatile years on record, with concerns about European debt at the forefront of investment markets for much of the year.  While at the corporate level, most companies quietly continued to grow their profits and bond holders earned good returns.

The volatility we have seen in equity and commodity markets is an unpleasant by-product of short-term sentiment - For the long-term investor or those with a contrarian bent, this volatility can create opportunities to purchase assets at attractive prices. 

While volatility can be genuinely detrimental and unnerving, the greatest risks for the long-term investor, come at the individual security level rather than within the market. When companies perform poorly the resulting loss of investment income and/or a permanent loss of capital can be highly damaging, and unlike volatility cannot be ridden out.

Successfully, managing these investment risks is a key component in a long-term investment strategy.

Kris Vogelsong, January 2012

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