Warren Buffett once said, “wide diversification is only required when investors do not understand what they are doing.”
The knock on spreading funds across a variety of assets has traditionally been that such a composition saps a portfolio’s power. The upside, of course, is it limits risk exposure, which is particularly compelling during times like these.
With all due respect to the Berkshire Hathaway BRK.A, -0.23% boss, even for those in-the-know, diversification doesn’t have to put a cap on potential returns.
In fact, according to Mark Rzepczynski, of advisory firm AMPHI Research, if properly constructed, there’s actually more upside to a globally diverse, multistrategy, multiasset class portfolio.
He used this illustration from Adam Butler of ReSolve Asset Management to show the power of low correlation. Rzepczynski describes it as “the single most important chart for any portfolio manager or investor”:
“When someone says ‘diversification is the only free lunch in finance,’ the phrase may not truly resonate as well as a picture, and the picture above says it all,” he wrote on The Disciplined Systematic Global Macro Views blog. “I can honestly say that for all of the educating in investments, this picture is not used enough.”
He starts with a risk-adjusted return of a single asset and then adds asset classes that have the same risk but different correlations.
“The power of diversification is explosive when correlations are low,” Rzepczynski said. “There is nothing to get excited about if there is high correlation across assets classes, but it should cause any investors or portfolio manager to jump out of his chair if he starts adding in low correlation assets.”
Easier said than done. The obvious first step is to add fixed income, the great diversifier over the years, to your equity portfolio. Then commodities. After that, it gets