There are few investment sayings repeated as often as the assertion that diversification is the only free lunch available to investors. The idea is generally attributed to Harry Markowitz, whose work demonstrated that investors could reduce certain risks by spreading their money across investments that behave differently from one another, rather than allowing their financial future to depend too heavily on a single company, country, asset class or investment outcome. The expression does not mean that diversification removes the possibility of loss, nor does it promise better returns every year. Instead, the ‘free lunch’ lies in the opportunity to reduce the damage that any one poorly performing investment can cause without necessarily sacrificing the portfolio’s long-term return potential.

While the principle sounds relatively straightforward, putting it into practice is considerably more difficult. Let’s unpack.

Owning more funds does not necessarily mean greater diversification

One of the most common mistakes we encounter is the assumption that the number of investments in a portfolio determines how well diversified it is. An investor may own several unit trusts, exchange-traded funds and direct shares, but if those investments hold many of the same companies or are exposed to the same markets, the portfolio may be far less diversified than it appears. In other words, five funds are not necessarily better than three, particularly where those funds are all trying to do much the same thing. In fact, adding more investments without understanding what lies beneath them can create duplication, unnecessary costs and a portfolio that becomes increasingly difficult to manage.

True diversification is not about filling an investment statement with as many different fund names as possible, but rather about ensuring that the portfolio is not overly dependent on one type of investment performing well. This could mean spreading your capital across local and offshore markets, shares, bonds, property and cash, while also making use of investment managers who approach markets differently. Naturally, the appropriate combination will depend on the investor’s objectives, investment time horizon, income needs and ability to tolerate short-term market movements.

Diversification needs to be designed

In developing a well-diversified portfolio, it’s important that each investment is selected for the particular role it needs to play within a broader strategy. Some investments may be included to generate long-term growth, while others may provide income, stability or access to capital. Offshore investments may reduce the investor’s reliance on South Africa and provide access to industries that are not well represented locally. Cash may appear unexciting when markets are performing well, but it can be invaluable where an investor has short-term expenses and wants to avoid having to sell growth assets at an inopportune time.

The challenge is that these decisions cannot be made in isolation. For example, an investment that appears attractive on its own may add very little to a portfolio that already has substantial exposure to the same companies, sectors or market conditions. This is one of the reasons we believe in using a well-selected discretionary fund manager, or DFM, as part of the investment process – because a DFM helps to bring together the different parts of the portfolio in a considered manner. Rather than selecting funds individually and hoping that they work well together, the DFM researches investment managers, considers how their funds complement one another, identifies unnecessary overlap and adjusts the portfolio as markets and the underlying investments change.

A portfolio cannot simply be built and forgotten

Importantly, diversification is not a once-off exercise completed on the day an investment is made. Over time, markets move at different rates, fund managers adjust their portfolios, investment teams change, and the balance between local and offshore assets can shift. For example, where offshore markets perform particularly well, the offshore portion of a portfolio may grow well beyond its intended level. Similarly, a fund that was originally selected because it offered a particular type of exposure may gradually change in character or begin to overlap with another fund in the portfolio. One of the benefits of a DFM is that they can monitor these changes and rebalance the portfolio where necessary, while also assessing whether the underlying fund managers remain appropriate.

Proper diversification can feel uncomfortable

Although diversification makes sense in theory, it can be emotionally difficult to live with because a properly diversified portfolio will almost always contain something that is not performing particularly well. For instance, when offshore markets are performing well, you may begin to dislike your local investments; or, where a particular investment theme, such as AI, is receiving widespread attention, everything outside that theme can seem disappointing. While the temptation may be to sell whatever has recently underperformed and move the money into whatever has done well, the reality is that this often results in investors buying after prices have risen and selling after values have fallen.

For long-term investors, diversification means accepting that not every component of the portfolio will perform well at the same time. In fact, if everything in a portfolio is moving in the same direction, the investor may not be as diversified as they believe. Remember, the objective is not to own only the best-performing investments but to build a portfolio that does not depend on correctly predicting which market, currency, fund manager or asset class will perform best next.

More diversification is not always better

That said, it’s also important to keep in mind that there is a point at which diversification can become an unnecessary complication. A portfolio containing too many funds may be difficult to understand, expensive to manage, and so widely spread that the strongest investment ideas make very little difference to the overall outcome. While investors can most certainly benefit from using a DFM, note that this does not automatically guarantee a better investment result. The quality of the research, the portfolio construction process, the ongoing oversight and the additional cost must all be considered when selecting a DFM. Investors and their advisers should be able to clearly understand what value the DFM provides and why each component of the portfolio has been included.

Ultimately, diversification is an acknowledgement that none of us knows exactly what the future holds. As financial planners, our role is not to build investment strategies that rely on a single forecast being correct, but to create financial plans that remain resilient when markets behave differently from what was expected. While diversification may be described as the only free lunch in investing, it still needs to be prepared carefully to ensure that no single company, country, sector, asset class or fund manager is given the power to determine the success or failure of the investor’s broader financial plan.

Have a beautiful day.

Sue