You have no doubt encountered the term “diversification” in your investment travels - somewhat of a buzzword in investment circles. At its simplest, it is described as not having all your eggs in one basket. It is one of the only guaranteed ‘free lunches’ in investment. This is especially the case for an investor seeking long-term returns with well-defined risk and return characteristics. Cameron Harrison’s investment philosophy has embraced diversification benefits for over 30 years. For long term portfolio investors, it is indeed a “free lunch” to enhance risk-adjusted returns.

Diversification is about achieving optimum risk outcomes for given desired returns over time. Owning multiple shares spreads risk across multiple companies, achieving superior risk outcomes than holding a single company. Better again is investing in multiple securities across asset classes. The image below shows the layers to achieving diversification. The mathematical foundation for diversification in investing is rooted in Modern Portfolio Theory – one of the most significant financial studies – that proves an investor can achieve a more efficient, superior portfolio by combining assets. Importantly, the typical stock in the market has twice the volatility (risk) than a diversified portfolio, yet the same average return.

When managing all your wealth, having a multi-asset class investment strategy is hence essential to achieving true diversification and optimum risk outcomes.

Different asset classes have different drivers of return. Rarely are the perfect conditions seen in which all asset classes perform well (if only!). In Cameron Harrison’s Multi-Asset Class Strategies, we invest across:

The central tenant of asset allocation is diversification. By investing in a range of asset classes that are not correlated, we are able to increase the expected long-term return and reduce volatility. This concept is not new, and at its core, is the opposite of ‘putting all your eggs in one basket’.

In the 1960s, Harry Markowitz proposed that by investing in assets that were not highly correlated, an investor could increase their return per unit of risk exposure. He further identified that there was an optimal combination of assets that would maximise the return for each unit of investment risk.

He called this the Efficient Frontier (see diagram below). The diagram illustrates this by comparing the return of multi-asset allocation strategies with varying levels of risk, to that of an equities only portfolio (domestic and global). We see that each of the multi-asset strategies sits on (or near) the Efficient Frontier, whilst the risk-return for the equities portfolio sits below the Efficient Frontier.

In the case of the equities only portfolio, this indicates that the same level of return could have been generated with less risk by combining the portfolio with other asset classes. Conversely, a higher absolute return, with lower risk, would have been generated by the high growth asset allocation strategy.

Asset allocation strategy is a core element in our process of planning and goal achievement with clients. It enables you to realise sustainable long-term real growth in income and capital value within a sound risk management framework. The Cameron Harrison Multi-Asset Class risk spectrum and our bespoke asset allocation strategies are formulated and operated through our proprietary “CH Wealth Pilot” program to assess, test and stress portfolio risk outcomes.

How do you optimally diversify say, the Australian Equity portion of the portfolio? Studies suggest that holding 20-30 stocks across different sectors can achieve the desired benefits of diversification, provided this is done with careful attention to sectors. Beyond 30 stocks, additional holdings provide marginal diversification benefits, but transaction costs and management complexity increase.

An ASX200 ETF (exchange-traded fund) tracks the performance of the 200 largest companies in Australia which on face value, would seem like a high level of diversification. The issue with the index in ETF’s is the market weighting methodology applied, which leads to concentration risk. This means a large portion of the fund’s performance can be influenced by a small number of stocks. Reviewing the ASX200 on a closer level:

‒ 53% of the index is either Financials (34%) or Materials (19%), heavily skewing the index

– CBA represents nearly 11% of the ASX200, a significant overweighting and influence on performance

‒ 40% of the index is made up of the top 7 holdings alone

The significant skew in the Australian index potentially offers an inferior risk outcome if you are seeking true diversification and shows the dangers in the assumption that passive investing achieves real diversification. Rather than market weighting, Cameron Harrison applies equal weighting as one of the key risk management tools in portfolio construction. This avoids excessive concentration in a few large-cap stocks, reducing the risk associated with any single stock or sector.

Cameron Harrison’s Equity Strategies cover Australian Equities (est. 1994) and Global Equities (est. 2008). Cameron Harrison aims to achieve real growth and a consistent stream of income over the long term, regardless of rises and falls in the equity market. We combine portfolio construction with a focus on quality – management excellence and financial robustness, meaning our portfolios benefit from a virtuous circle of secondary characteristics, including superior risk attributes, sustainable income, long term capital growth, and inflation protection.

Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.  

For more information on our approach to investment strategy, please contact us on +613 9655 5000 or contact our experts here.