Most readers would be familiar with the phrase “don’t put all your eggs in one basket”. This phrase is believed to have first appeared in the novel Don Quixote in the early 17th century. It aptly describes the concept of diversification, which in an investment context is the act of reducing company specific risk by investing in a variety of businesses, asset classes or geographies.

Diversification in Everyday Life

The concept of diversification could be applied to many different settings. For example, farmers might want to vary crops to mitigate the risk of pests or disease impacting their harvest. Businesses are well aware of the need to have a variety of suppliers to protect against supply bottlenecks or delays. Individuals might want to diversify their income streams by having a source of passive income apart from their day job, such as a real estate investment, side business or stock portfolio. This could help contribute to financial security in uncertain times and enhance wealth creation.

Business Diversification: Successes and Failures

Many local and international businesses pursue a strategy of diversification to achieve growth whilst spreading risk and tapping into various opportunities. There are numerous examples of Maltese businesses that morph into completely different businesses over the years. Some starting out as engineering, shipping or trading companies and becoming conglomerates with interests in sectors such as retail, hospitality, real estate and technology. Internationally, some revenue diversification attempts have worked better than others. Disney is a good example of a company that has adopted a diversification strategy after expanding from an animation studio into theme parks, television networks, and streaming services via Disney+. Amazon started as an online bookstore and now has moved into cloud computing, streaming services and groceries and other segments. However, some diversification efforts do not do as well. For example, Harley Davidson once tried to sell Harley-branded bottled water. Starbucks tried to diversify into offering Starbucks-branded furniture. Both ventures failed. Some companies need to diversify to survive. Zippo, for example, is trying to follow a similar path to Victorinox and offer a more varied product portfolio as the future for lighters looks bleak with smoking becoming less popular in many countries.

Diversification in Investment Portfolios

In the investment world, diversification is one of the most important strategies for Portfolio managers to adopt. It helps to mitigate risk by reducing the impact of individual investment losses. If one investment underperforms, the losses can be offset by gains in other investments within the portfolio. Diversification is one of the key components of Modern Portfolio Theory. American economist Harry Markowitz pioneered this theory in his paper ‘Portfolio Selection’ which was published in the Journal of Finance in 1952. He later won the Nobel Prize for his work. Modern Portfolio Theory helps investors understand the trade-off between risk and potential return. Investors should strive to maximise return for a given level of risk. Most investments are either high risk and offer high returns or low risk offering low return. Markowitz showed that investors could achieve their best results by choosing an optimal mix of different investments, according to one’s risk tolerance. Diversification does not only depend on the number of stocks or bonds within a particular portfolio but also on their correlation with each other. If all the asset prices move in the same direction during market events, you won’t benefit from diversification as much. A mix of low correlation assets provide better diversification.

How Much Diversification is Enough?

Various studies have investigated the optimal number of investments in a portfolio to achieve maximum reduction in risk. Most have concluded that since there is a diminishing marginal benefit of adding more investments. Beyond 30 to 40 instruments, most of the benefits of diversification tappers off with the largest benefit achieved with the first few. There are various high-profile examples of individuals and institutions that suffered significant financial losses due to a lack of diversification in their investments. These cases often serve as cautionary tales about the dangers of too much concentration. When Enron collapsed in 2001 due to accounting fraud, some employees had as much as 60% of their retirement savings in Enron stock which became worthless. The Betchel Family, known for their construction and engineering business, lost billions in the 2008 financial crisis due to a heavy concentration in Nevada real estate which was one of the hardest hit states in America during the crash.

Why Diversification is Crucial for Long-Term Success

Investors would be wise to diversify and not to put all their eggs in one basket. This strategy will enhance long term risk adjusted returns and help achieve long term goals whilst protecting against market downturns. Diversification can also smoothen portfolio performance, reduce the impact of market cycles and reduces emotional investing by dampening the impact of market volatility. As Harry Markowitz famously said, “Diversification is the only free lunch in finance”.

Written by

Michael Tabone, CFA

Senior Portfolio Manager, ReAPS Asset Management Ltd

The information contained in this article represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell / buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments. This article was issued by ReAPS Asset Management Limited, a subsidiary of APS Bank plc. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.