A new year, a new column, old lessons

The New Year is traditionally a time when investors review their performance over the previous year and look to amend their portfolios in the search for this year’s winners. The finance pages are awash with this year’s stock and fund tips from the great and the good of the marketing…sorry investment industry.

2007 will undoubtedly be remembered for the ‘credit crunch’ bought about by the collapse in the US sub-prime mortgage market. Hedge fund managers talked in terms of ‘six-sigma’ events happening, which statistically should happen only once every 796 years. Others thought the conditions even worse. Lehman Brothers head of quantitative equity strategies, Matthew Rothman said:

“Events that models only predicted would happen once in 10,000 years happened every day for three days."

Benign economic conditions and rising capital markets rarely expose the dangers inherent to many investors’ portfolios, but market turmoil tends to uncover weaknesses, sometimes with disastrous consequences. Even the ‘black-box’ mathematical models of the worlds best hedge fund managers cannot cope with the force of the markets when they move.

Undoubtedly one of the saddest episodes of the year was the fall from grace of Northern Rock and the impact on the tens of thousands of small shareholders. Northern Rock shares lost 92% of their value over the calendar year, compared to a fall of just 2.5% for the FTSE All-share index. I use the word ‘sad’ because the severe impact on small shareholders financial positions could largely have been avoided. Whilst I can sympathise, they only have themselves to blame because they ignored one of the cardinal rules of investment – diversification.

Diversification or ‘don’t put all your eggs in one basket’ in simple terms, was first scientifically studied by Harry Markowitz in 1952. His seminal work not only earned him a Nobel Prize but changed the way we build portfolios forever. Markowitz proved that a diversified portfolio is greater than the sum of its parts, and allows an investor to reduce their risk without reducing their expected return. The risk reduction comes from reducing the ‘stock selection’ risk – i.e. the specific risks attaching to one company. For example, Northern Rock’s business model had a structural weakness, which caused its virtual collapse when short-term corporate borrowing rates rose dramatically above central bank base rates. This is a stock specific factor. By investing in a ‘diversified’ portfolio of shares which react differently to varying economic conditions you can remove all stock specific risk and leave only the residual ‘market risk’. Market risk is ever-present and cannot be negated. The FTSE all-share fell by 2.5% in 2007 demonstrating the market risk of the UK stockmarket. So by investing in the broad market rather than in Northern Rocks shares, we can see that risk is dramatically reduced. But just as important is that the expected return from the diversified ‘market’ portfolio is hardly affected. How can this be? The expected return from medium to large companies such as Northern Rock is quite similar. Why should investors demand a higher return from a medium size bank than a medium sized retailer, with the same asset backing and growth prospects? There is no reason. So by selecting a portfolio of shares across sectors, both large and small and also from different countries you can diversify away all stock selection risk and country specific risk from your portfolio. Then by investing across asset classes, such as equities, bonds and property you can add further diversification.

Investors who ignore the power of diversification are missing out on the best ‘free lunch’ in the investment world, and for what? For nothing, they are gaining no higher expected return but they are exposing their portfolios to the chance of ‘bombshells’, such as the northern rock fiasco, blowing their future financial wellbeing to kingdom come.

To diversify private investors need to forget about owning individual shares, they just don’t have enough cash to make it cost effective or practical. Collective funds are invariably the best way to provide the highest level of diversification, whilst keeping charges and taxes to a bare minimum.

So my three tips for 2008:

1. Forget the stock tips you see in the personal finance press and leave share ownership to the hopeless dreamers, speculators and gazillioanaires.



2. Review your portfolio and ensure that you are benefiting from the power of diversification so you can see out the inevitable choppy waters that lie ahead in world capital markets.



3. Even diversification cannot prevent the ups and down of capital markets. Risky assets command a ‘risk premium’ and therefore a higher return because of their additional risk. This is an immutable truth. Don’t put your faith in investments which seemingly achieve the alchemy of modern finance - high returns with low risk. 2007 was a year which demonstrated once again that so-called ‘freak’ economic conditions happen far more often than the statistics would suggest. So only invest in what you understand and in investments which have a fundamental reason for the return that they offer.

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