Spread Risk, Strengthen Your Plan: Why Diversification Matters

We all know you need to take a risk at times. But how can you take the right risks with your wealth and make the most of the returns available? Welcome to diversification. There’s a forest of academic material devoted to it… and it’s mostly unreadable. So, let’s start with a not so little Fugger.

Rich as Fugg

Was Jakob Fugger the richest man ever? It’s hard to make these comparisons over time… Malian emperor Mansa Musa, John D Rockefeller and a few others are on the list. Elon Musk is probably bubbling well under the top ten. But Fugger has a good claim.

We mention him because we’re looking at the advantages of spreading your wealth, to lower risk and boost returns. And he knew all about that, according to his family’s official website:

“Following the Fugger tradition, the trading houses rested on four pillars: long-distance trade, mining in the Alps and Carpathians, large-scale banking, and publishing, i.e., the decentralized organization of industrial mass production, primarily textiles.”

He’s not the first diversifier. After all, the Bible’s Old Testament advises diversity in investing. But he was probably the most famous for some time.

Then Harry arrived, with something magical.

A Chamber of Secrets

He found that an investor faced by two portfolios with the same return will always choose the least risky one.

This is of course Harry Markowitz’s ‘modern portfolio theory’, which bagged him the 1990 Nobel prize in economics. The theory includes something that Fugger knew well: an investor can reduce risk if they hold combinations of instruments that are not correlated.

Correlation is the causal relationship between two things. If something can move one thing upwards – any US large company shares, say – it will also move anything correlated to it – such as global shares.

That’s fine, but when your US large company shares go down, you want things likely to stay stable or even rise in value. History says UK real estate is driven by very different factors and tends to have a low correlation.

A simple way of spreading risk is shares and bonds. When one shoots the lights out, the other can lower your overall risk. And when one plunges, as it will inevitably do from time to time, its companion can hold the portfolio up.

No Crystal Ball

We don’t just diversify across different types of investment (shares, bonds, property, commodities like coffee or steel, infrastructure and so on).

We also diversify within each of these types of investment. And that’s because no-one knows what will happen.

For example, the fund managers at Dimensional take a scientific approach to investing, using ideas from Harry and other smart thinkers. And every year they produce this amazing book of investment data. We will cut to the chase, which is this chart showing just how random investment markets can be.

The best returning country in the most recent year? Italy in 2023, with 37%. The best over the last two decades? Norway in 2009, with 87.1%.

But imagine you’d followed the money and piled into Norway in 2010. You’d have made a very good 10%, but then lost 10% the year after. Austria’s 42% in 2021 sounds great – it’s -26% in 2022 less so. Look at the chart and you’ll see similar examples everywhere. It’s just impossible to know exactly how markets will perform.

So, you spread your risk across asset types and countries and try and max out your chances of doing well.

In fact, the science says you can also diversify across sectors – such as consumer staples (namely the things you need, like household items and food) and consumer discretionary (like athleisure goods, electronics and eating out).

There are all sorts of ways you can spread risk and invest like Fugger. Just don’t fall into two popular traps:

• Naive diversification is when you spread money across the things you know, or can see, or have access to. It’s a false comfort.
• Excessive diversification is too much of a good thing, where you can lose track of what you have and how they relate to each other.

If we can help explain why your money will be better off in the right number of investments, get in touch. We’d love to talk. We’re on 020 7467 2700 or at hello@firstwealth.co.uk.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.