The following is an extract from Scott Francis' book - Your Guide to Being a Successful CEO of Your Life

Using Diversification and Asset Allocation to Build an Effective Portfolio

Diversification is a strategy to manage investment risk by investing in a variety of assets.  In this way, if one of the assets you have invested in performs poorly, the overall effect that this has on your portfolio is moderated by the performance of the other assets. 

Put simply, diversification is making sure that all your eggs are not in the one basket.

To understand how diversification works as a strategy, let us consider what happens when an asset that you own falls in value by 50%.  While this is not a common occurrence it can happen.  High profile examples of assets that have fallen by more than 50% in recent times would include AMP shares, Flight Centre shares (although both these companies have since recovered), Centro Property shares, ABC Childcare shares, City Pacific Shares or HIH and OneTel shares that collapsed completely.

The effect that a fall in value of an asset by 50% will have on your overall portfolio will be moderated by how many investments you have in your portfolio.  If you only have this one asset in your portfolio, the effect on your portfolio will be a fall in value by the same amount as the asset, which is 50%.  If you have 5 equally weighted assets in your portfolio, and one falls by 50%, then the effect on your portfolio will be that it falls in value by 10%.  With 10 equally weighted assets the overall portfolio falls by 5% if one asset falls in value by 50%.  By the time you have a portfolio of 20 equally weighted assets the overall portfolio only falls by 2% when the value of one asset falls by 50%.

Most of the benefits of diversification are gained by the time you have 15 to 20 assets in your portfolio.  Beyond that the gains from diversification are not significant.

Chris Leithner, in his book 'The Intelligent Australian Investor' (Wright Books, 2005) makes the point that up to the point of 'fifteen to twenty securities or thereabout, diversification is indeed beneficial'. 

Warren Buffett, perhaps the greatest investor of all time (and who is the subject of a later chapter in this book), is another who warned against over diversification.  Robert Hagstrom, in his Book 'The Essential Buffett' (Wiley and Sons, 2001) described Warren Buffett's investment style as 'focus investing', where he is comfortable holding a smaller portfolio of outstanding investments.  The lesson is, 'Best way to outperform the market: Don't load up on hundreds of stocks; wait for the few outstanding opportunities.'

Robert Hagstrom tested the theory that smaller portfolios had greater probability of generating returns that are higher than the market's average rate of return.  He used a computer simulation to randomly generate 3,000 portfolios containing different numbers of stocks, from a data set of 1,200 companies. 

The largest portfolios contained 250 stocks, and the average 10 year return from the 3,000 portfolios containing 250 stocks ranged between 16.0% and 11.4%.  The smallest portfolios contained 15 stocks and the average 10 year returns from the 3,000 portfolios containing 15 stocks ranged between 6.7% an 26.6%.  This demonstrates that the smaller portfolio has a greater chance of both outperforming and under performing the overall investment market.

This is an important point - the less diversified the portfolio, the greater the risk of underperforming the market by some margin.

My own view is that diversification is a great ally.  As you will see in later sections of the book I favour whole of market index style funds for portfolios.  The Hagstrom figures given above show that as portfolios become smaller, there is also greater chance of them underperforming the market by greater margins.

So, having looked at both the importance of diversification and the disadvantages that may come with too much diversification we now move on to look at another tool to moderate investment risk, asset allocation.

Asset Allocation

There are various asset classes that are available for people to invest in.  These include:

• Australian shares,
• international shares,
• listed property trusts,
• direct property,
• fixed interest investments,
• cash investments. 

All of these individual asset classes are explored in more detail in the next section of the book.  Here we are going to look at choosing how much of our portfolio we should allocate to each asset class.

We should start by looking at the question why invest in more than one asset class?  Shouldn't we simply invest in whichever asset class has the highest average return and reap the benefits of a high performing portfolio?

The answer to these questions is that we invest in different asset classes to try to reduce the volatility of our portfolio - that is the extent to which the returns of a portfolio fluctuate. 

For example, in the financial year ending June 2002 Australian shares returned -4.5% and then over the following 12 months they returned -1.1%.  A total two year period over which an investor in Australian shares lost money.  Over that same period, however, Australian fixed interest investments returned 8.0% and 12.2% and listed property trusts produced returns of 15.5% and 12.1%.  So, an investor's total return would have been improved by diversifying between asset classes - so that in that period where Australian shares provided a poor return, this would be offset from the relatively strong returns from fixed interest and listed property trust investments.

The various asset classes are often grouped under two categories, growth assets and defensive assets.  Defensive assets include cash investment and fixed interest investments like bank term deposits, government and company bonds.  Growth assets include Australian and international shares and listed property trusts. 

Defensive assets usually provide a known stream of income with little risk of losing capital. An example is a bank account, which has a very high likelihood that you will get your original investment back at the end of the investment period with an agreed rate of interest.  A government bond is another example with the 6 monthly interest payments known when you purchase the bond, and at the end of the investment period you will receive your money back.  Given that defensive assets generally have a known income stream and limited risk of losing your investment, it might also be appropriate to categorise them as 'income stream assets'.  These investments are less risky than growth assets, and also generally have lower average returns.

At this point it is worth mentioning that there are a number of providers of 'fixed interest' investments who deceive investors into thinking that they are offering relatively secure investments when they are not.  This is examined further in the chapter on fixed interest investments.  However they are not the type of fixed interest investments under discussion here.

Growth assets are those where the income distributions to the investor are not fixed, but rely on the underlying performance of the company or property investment.  The prices of these assets are volatile, that is they have the potential to both rise and fall in price, and there is no guarantee that an investor will get their original investment back when they come to sell.  These assets are riskier but tend to have a higher average return than defensive assets.  The ability of these assets to increase or decrease in capital value means that it is also appropriate to categorise them as 'volatile assets'.

Some organizations characterise listed property trusts as defensive assets because of their strong and generally reliable income streams.  However, with the increased use of debt financing by listed property trusts, and the increasing number of trusts involved in construction work, I think it is more appropriate to characterise them as growth assets.  This issue is discussed further in the chapter on listed property trusts. 

Choosing an Asset Allocation for Yourself

Alan Kohler, in his book 'Making Money' (Randon House Australia, 2005) emphasises that investment timeframe is important.  For long term investments, say saving for retirement from an early age, he suggests that a diversified mix of growth investments may be appropriate.  Conversely, if the investment period is short, say you want to invest a lump sum needed to purchase a house in two years, then investing that totally in cash or term deposit investments where there is no chance of a negative investment return is sound.

As well as timeframe, an investor's comfort with volatility is often important in choosing an asset allocation.  An investor who is comfortable with the value of their investments going up and down in exchange for a higher long term return is more likely to invest in growth asset classes.  An investor who is not at all comfortable with fluctuations in the value of their portfolio is more likely to invest in defensive asset classes.

While different terminology is used, the 'average' asset allocation is often referred to as a 'balanced' portfolio.  Portfolios that have more of a bias towards growth assets than the balanced portfolio are often called 'growth' portfolios.  Portfolios  that have more of a bias towards defensive assets than balanced portfolios are often called 'income' or 'conservative' portfolios. 

So what does an average balanced asset allocation look like?

I have put together a summary of the asset allocations of a number of fund managers. These are in the table on the next page.  As you can see, there is a degree of variety as to what constitutes a balanced fund.  For example, Q Super's balanced fund targets having 75% of its investments in growth assets, whereas Vanguard has 50% of its investments in growth assets.  This in itself suggests that an investor should look behind the label and ensure they are comfortable with the actual asset allocation of any fund. 

My own asset allocation shows up my bias for asset classes that produce strong income streams.  I prefer a higher than usual exposure to listed property trusts, an asset class characterised by strong income streams.  Furthermore I would choose a lower than usual exposure to international shares as they tend to have the lowest income streams of any asset class.

To move any of these balanced asset allocations into more 'assertive' or 'growth orientated' asset classes you could increase the exposure in the area of Australian shares, international shares and listed property trusts.  Indeed, for very long term investments you may have only minimal exposure to defensive assets.

Conversely, to make any of these balanced asset allocations into more 'income' or 'conservative' asset allocations, increased exposure to fixed interest and cash assets is required.

At the end of the day, as important as asset allocation is, it is not an exact science.  As you build your understanding of investments and how they perform no doubt you will build your own preferences for your own asset allocation. 

We look at this topic in more detail in the section of the book that looks at investments.

How To Proceed From Here:

This chapter is primarily theoretical.  Having read through this chapter you are now in a position to decide how you are going to put into practice the concepts of diversification and asset allocation.

You should be in a position to decide what level of diversification you feel comfortable with.  Certainly you would want to have a portfolio of more than 10 assets, although there is little benefit and indeed some downside in have more than 20 assets in your portfolio.

You should now have a working understanding of what sort of asset allocation you are comfortable with, and you will no doubt build this understanding over time.