Diversifying your portfolio is not as simple as just adding more assets, according to a new report which found a random approach to diversification will only get a person so far.
A research paper by investment firm, Blackfinch, looked at what diversification means and how it works for investors.
Dan Appleby, chief investment officer at the group, said the paper aimed to provide insights for advisers as they look to alternative investments for their clients in the face of rising interest rates and economic uncertainty.
Appleby, who changed careers from engineering to finance, took a data driven approach to the topic.
He said the study started with the assumption that the correlation of the assets he was adding to a test portfolio was zero - Correlation is a measure of how different investments move in relation to one another.
He said: “Correlation is the mathematical or quantitative measure for how different the assets are that you're adding into your portfolio.
“When I was playing around with the theory and changing that assumption, I found out the underlying assumption that you commonly see in our chart is that the correlations are zero.”
In reality, there are few assets that correlate at zero with another asset in a portfolio and would be unheard of in portfolios of 20 or 30 assets.
Appleby added: “What I did mathematically is just randomise the correlations for revenue assets that I was adding into the portfolio and what I actually found - and this is the part I didn't guess - is that the random investor really actually did quite well up until roughly the 10th asset and the investor reduced their portfolio risk quite significantly.
“Then what actually happened after the 10th to the 11th and 12th asset was that even though there were more assets in the portfolio, the portfolio risk actually increased, which is the exact opposite to what you really think of diversification.
“[You think] I'm gonna add assets in my portfolio, I'm going to be diversified, I'm going to reduce my risk.”
When starting out with his research, Appleby considered whether people with pensions were missing out by not using tax efficient investments.
He went on to compare the outcomes of different pension approaches for a client with a £500,000 pension pot and 15 years left in retirement.
He found that a typical 60/40 portfolio compared to an optimised additional asset class portfolio would benefit from around £65,000 more just from diversification and not taking into account any other tax benefits.
Appleby concluded that it was not “all or nothing” and he did not think those who have never considered high risk products should move their whole pension portfolio over to them.
He added: “We aren't trying to reinvent the pension wheel here.
“We should absolutely start with that quality allocation to stocks and bonds. But maybe a portion of the pension could, if they were going to allocate it to the tax efficient space, have diversification benefits to just enhance it that little step further.”
