Portfolio Diversification: When Return Of Capital Trumps Return On Capital
Note: This article originally appeared in Billionaire Magazine on March 8, 2017.
As Warren Buffett famously quipped, “Diversification may preserve wealth, but concentration builds wealth.” He was right, of course. It is intuitively pleasing that, by utilising portfolio diversification to smooth out the volatility of our returns, we will always miss out on some of the upside when a particular asset class outperforms. The corollary, though, is that portfolio concentration requires exhaustive knowledge of the asset – what I mean by this is that, by putting all of your eggs into a particular basket, you are wagering that you know the upsides and the risks of that particular basket better than the market does. This level of expertise happens to feature very highly into Mr. Buffett’s investment thesis and, as we know, has served him very well.
But what if we don’t share Mr. Buffett’s expertise and ability to focus on a finite number of investments on a full-time basis? Many of us have neither the capacity nor the inclination to maintain the level of focus required to benefit from a concentrated portfolio. Instead, if you are like me, you would rather think about your investment portfolio in terms of a long (and somewhat boring) journey upward as opposed to a Las Vegas thrill ride.
There are many ways to achieve diversification and each has its own merits and pitfalls but whatever method you choose you will want to be sure that your plan covers the following points:
1. Insulate from risks in your primary earning sector
You may derive the bulk of your income from a given industry – imagine, for instance, that you own a privately-held oil company – in order to reduce exposure to the energy sector you may structure your portfolio to intentionally de-risk you there.
2. Reduce systemic risk
Regardless of where you reside, every jurisdiction has its in-built risks. Examples can range from the mundane; say the risk of a new punitive tax on high net worth individuals, to the profound such as nationalisation of assets or overthrow of the government. These risks are dealt with by owning assets in multiple geographies, ideally in markets with low correlation. You may also consider further protecting your portfolio by dividing it among several custodians in multiple currencies.
3. Sector risk
Almost all asset classes and the sectors within them are easily investible today either by purchasing individual securities, ETF’s or index-linked structured products. You can easily structure a responsibly diversified portfolio and, if you are so inclined, even tailor it to focus a bit more heavily on the industries or regions that interest you the most.
4. Manager or key-man risk
You may elect to address some of the above by engaging a professional manager. This can be as simple as buying a mutual fund or as complex as making the decision to open a family office. In either case though you will want to be sure that you do not rely on a single company, or worse, a single manager to make all of your investment decisions. Ideally your managers will be unrelated and will have a fiduciary responsibility to you ahead of all others.
5. Be prepared to rebalance
If you work with an active manager, you will already know that they constantly rebalance portfolios to favour asset classes that are on the upswing, while de-emphasizing those whose outlook turns negative. This discipline and skill allows investors to achieve a more favourable and consistent overall performance.
6. Remember the alternatives
By keeping a small percentage of your portfolio in reserve for less liquid or alternative assets you maintain the ability to capitalise on opportunities that, while risky, may result in significant upside.
Keep these six points in mind as you build your investment portfolio and, whether you elect to manage it yourself or retain outside advisers, you will sleep soundly knowing the journey is long and perhaps a bit boring but at least you are headed in the right direction.
Charlie O’Flaherty is partner — head of digital strategy & distribution at Crossbridge Capital. Crossbridge Capital is a global wealth manager who recently launched CONNECT by Crossbridge, Singapore’s first fully functioning robo-advisory platform for Accredited Investors.
The views expressed in this article are those of the author and not the author’s company. This material is provided for educational purposes and should not be construed as investment advice or an offer or solicitation to buy or sell certain securities.