In the mid-1990s a pharmacist from west London called Jayesh Manek won the Sunday Times Fantasy Fund Manager competition two years running. So when he started the Manek Growth Fund shortly afterwards, some big name investors were willing to back him. The fund was successful for a couple of years but with around 75% exposure to tech stocks it crashed badly when the the dot com bubble burst. In the years that followed Manek kept taking positions in high risk shares and became a case study in how under-diversification can destroy long-term returns.
Diversification doesn’t just mean ‘more’
Ed recently wrote about how investors tend to hold too few stocks in their portfolios. But effective diversification is not just about having more stocks in a portfolio. Simply adding more stocks is known as naive diversification, but to diversify skilfully, it’s important to understand the central concept of correlation. In simple terms, correlation measures how the returns of two assets (like two stocks) move together, up or down. Mathematicians will recognise this this type of measure of movement by another name - covariance.
Highly correlated stocks move in the same way as each other while those with low correlation move in opposite directions. It is measured quite simply on a scale from -1 (low correlation) through to 0 (neutral) to +1 (high correlation). And it’s calculated by studying past returns.
The advantage of examining correlation between stocks is that investors can diversify much more effectively than by just adding more shares. Finance geeks will tell you that this means you are improving your chances of getting a better return for the same risk or the same returns with less risk. It does this by helping to capture a wider range of stocks that do better at different moments in economic and market cycles. In other words, when one stock zigs, another will zag.
Most investors don’t get correlation
In an epic 2008 study of more than 60,000 trading accounts, US academics Kumar and Goetzman endeavoured to get to the bottom of why investors are so under-diversified. What they found was that the average number of stocks in a portfolio increased from four to seven between 1991-96. But this diversification benefit was naive. There was no evidence that those investors were using any skill to ensure those extra stocks were uncorrelated:
We do not find evidence of diversification improvement by active means, where investors select…
