Diversification. For generations, many investment professionals have stressed its importance as a means to manage risk whilst capturing the long-term growth many equity investors seek. But what does this actually mean? How can you assess whether you are adequately diversified? In this primer, Fisher Investments UK will share some basics on how we view diversification—and some common pitfalls to avoid we see regularly in investors’ portfolios.
In our experience, many investors hear the word “diversification” and think it means simply owning more than one security or a few securities. This is, to an extent, correct. But it also vastly oversimplifies the subject. Owning more than one security is a benefit—it reduces the risk that the company you select has issues specific to it that harm investment results. It can also mean you have a greater chance of including well-performing shares in your portfolio.
But diversification isn’t limited to this, in our view. Fisher Investments UK thinks you should also view diversification at the country and economic sector level. Consider: If you own three Energy companies, you may be reducing the risk that a company-specific factor hits your portfolio hard. But what if the entire sector faces a headwind? Our research indicates that, most of the time, shares in the same industry will perform similarly because they respond to similar drivers. In the Energy sector, our research shows oil prices are the chief driver. When they are weak and appear likely to remain weak based on supply and demand trends, we find Energy shares tend to perform poorly—with very few exceptions.
Take 2020 for an example. This year’s economic lockdowns and travel restrictions have hit demand for gasoline and other Energy products hard. Meanwhile, oil supply is elevated tied to vast increases in American production in recent years.[i] At 2020’s outset, Brent crude oil—the blend used to approximate global prices—traded at $67.77 per barrel.[ii] After lockdowns shuttered the global economy, it hit a low of $9.12 on 21 April.[iii] Economic reopening has helped—Brent prices finished September at $40.30.[iv]
But the damage to equities in the sector has been acute. Through 30 September, the MSCI World Energy sector was down -44.6% this year—the worst of the 11 broad equity sectors.[v] Energy shares felt that pain broadly. Of the sector’s 54 constituent companies, 49 were down year-to-date as of 30 September.[vi] Moreover, 45 were down more than -20%. Whilst blending together different Energy firms in your portfolio could have helped you find some that fell less than the overall sector, you were highly unlikely to find equities that rose.
In Fisher Investments UK’s view, this highlights the importance of owning shares across the array of equity sectors. Technology shares, for example, have no material connection to oil prices and are up notably on the year.[vii] We think it can be useful as a guide to break down a broad equity index like the MSCI World by sector. (MSCI provides factsheets showing this that are updated quarterly and available online.) That way, you have a reference point to understand how big (or small) that sector is. This can help you determine whether you have enough—or too much—exposure. This doesn’t mean you need to mimic the index’s sector weight perfectly, in our view. It is merely a starting point.
This reference point can help you avoid the common pitfall of ignoring some sectors whilst concentrating in others. In our experience, investors often unwittingly do this because equities in one category they own are doing well whilst others aren’t. They often sell the laggards and chase the better returns. Maybe that sounds sensible, but we think it actually adds risk. No sector is permanently in favour and you could suffer if leadership rotates. Diversifying properly, in Fisher Investments UK’s view, means owning things that are both in and out of favour.
Another common error we see often is people owning way too much of a single company’s shares. Some do this because they used to work there, are fans of its products and services or they are otherwise emotionally attached to it. But unless you are legally restricted from selling it for employment or other reasons, in our view, this is a problem worth rectifying immediately. We have unfortunately encountered many retirement investors whose portfolios were devastated by owning too much of a single firm’s shares.
So we think investors benefit from spreading their assets around. Own more than one company’s shares. But don’t ignore sectors and countries as you do so. In Fisher Investments UK’s view, this is a key step toward building a sound retirement portfolio.
Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
[i] Source: US Energy Information Administration, as of 15/10/2020.
[ii] Source: FactSet, as of 15/10/2020. Brent crude price on 1/1/2020. Oil is universally priced in US dollars.
[v] Source: FactSet, as of 15/10/2020. MSCI World Energy sector return with net dividends, 31/12/2019 – 30/9/2020.
[vi] Source: FactSet, as of 15/10/2020. Total return of MSCI World Energy sector constituent equities, 31/12/2019 – 30/9/2020.
[vii] Source: FactSet, as of 15/10/2020. Statement based on MSCI World Information Technology sector return, 31/12/2019 – 30/9/2020.