Diversification: Risk and Reward

Published by Brett Carson, Director of Research, and the Carson Group Partners Investment Committee

Diversification is a cornerstone of portfolio risk management. In short, investors should spread capital among various assets to attempt to reduce volatility and avoid being wiped out by one poor decision. However, when taken to an extreme, it can lead to disappointing returns. Compared to owning a single stock, the potential benefit of two can be enormous. However, the incremental benefit of owning 55 stocks instead of 50 is minimal. For passive investors seeking to mirror benchmark returns, being too diversified is not a major issue. For investors that seek to generate outperformance over time, it is important to recognize that over-diversification can become a hindrance towards addressing this goal. Too many active managers suffer from this very phenomenon. Layer on the high fees charged by many, and they essentially become no longer a cost-efficient option. Thus it is important that investors pay attention to diversification and understand their investment’s objective and its fees charged.

Company specific risk has a negative connotation and pundits of passive investing argue that the risk is unrewarded. We disagree. Company specific risk comes in many forms, such as a rogue trader pushing down its share price or product recall that impacts one business but not the industry. Certainly diversification reduces the impact of these risks to a portfolio; however, what is often ignored are the potential for positive events, like a business being acquired or developing a revolutionary product.  Investors need to find the right balance between the risk reduction benefit of diversification while leaving opportunity to differentiate performance from its benchmark. Too often, active managers deviate only slightly from the index which results in performance that closely mirrors the index.

The choice to eliminate or accept company specific risk is largely decided by an investor’s goals. Is it to track a benchmark or outperform it over time? Passive investors have a plethora of investment options. When selecting an active manager, investors must have an understanding of true active management. When a manager owns too many stocks, he or she is unlikely to capture the upside from his best performers and is not worth the added cost. A good active portfolio will be concentrated in the manager’s highest conviction ideas.

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