Stock market cycles and why diversification matters (2019)

By: Tim Bennett
05.09.2019

Diversification is a key principle that underpins long-term equity investing. Tim Bennett explains why in his updated core video.

Stock market cycles and why diversification matters (2019)

Diversification – the idea that stock market investors should spread their risk over a number of shares – is one of the keys to successful long-term investing. Here’s why.

Background

The stock market presents investors with several types of risk. Two of the most important are “single stock risk” and “market risk”. Diversification will help to protect against the first of these but not the second. For that, the right approach is key, a topic I touch on here further on and in more detail in my other core video, “Lifetime savings – the risks (2019)”.
The reason that single-stock risk is so dangerous is illustrated by the “Amazon illusion” as I call it. With the benefit of hindsight, an investor should have piled into this stock years ago.
But that is just the point – we don’t have hindsight as investors. And had someone piled into another once-popular stock such as Carillion, instead, the result could have been disastrous, as the next chart shows;

Why diversify?

In short, it is this single-stock risk that diversification tries to reduce. Otherwise, investors are effectively gambling their money, a strategy that is doomed to fail the majority.

How do we diversify?

There are many ways to achieve a diversified portfolio – here are three of the better-known ones;
The idea is to create a portfolio that is not dependent too heavily on the fortunes of any particular currency, country, sector or theme.

How many stocks?

A hotly contested subject is then how many stocks an investor needs to hold to achieve adequate diversification. This will very much depend on their personal preferences and objectives. However, the Capital Asset Pricing Model (CAPM) suggests that beyond about 15-25 stocks, the benefits of further diversification start to fade in terms of reduced single-stock risk. A hotly contested subject is then how many stocks an investor needs to hold to achieve adequate diversification. This will very much depend on their personal preferences and objectives. However, the Capital Asset Pricing Model (CAPM) suggests that beyond about 15-25 stocks, the benefits of further diversification start to fade in terms of reduced single-stock risk.
The potential benefits of adopting a diversified approach can be seen in the next slide. Whilst not a recommendation per se, this does show that an investor can hold their preferred stocks and generate market-beating returns, without needing to necessarily hold lots of them. There are also potential benefits to holding an evenly weighted portfolio rather than the market capitalisation weighted result that investors get from holding the whole market through an index.
7.-Stock-market-cycles-and-why-diversification-matters-2019.-How-many-stocks.-Example-700x398

What about market risk?

In fairness, diversification is no magic pill, should the stock market take a broad dive, something it has done at several points in its recent history.
What investors need to manage these market cycles is the right long-term psychological approach.

The right approach

To illustrate, let’s compare a £25,000 investment (the green line) in the early 1970’s, at the start of one of the worst stock market crashes most investors alive today will remember, with a cash account containing the same amount (the pink line).

The first few years are not pretty, as the stock market took a sharp dive – no amount of clever diversification would have protected an investor here.
However, widen out this picture and the benefits of staying invested, rather than running to cash, become apparent.
This is true if we inflation-adjust the picture too;
And even more so if we look at total returns, where income generated by investments is reinvested rather than withdrawn and spent.
In order to benefit from the long-term rise in stocks over this period, an investor needed to follow certain key steps;

Plan well

Point two in this list can cause headaches if investors fail to plan for large cash drawdowns, or what we call “foreseeable calls on capital”. An investment approach that divides future capital into three broad categories, or “pots” can help here. The idea is that an investor ring-fences emergency funds and invests the bulk of their long-term savings into equities as “lifetime savings”. Calls on capital are then separately planned for and managed as they arise.
To discuss how diversification can help you, or how the right planning strategy will allow you to make the most of stock market investing, please contact an Investment Manager or a Wealth Planner.