Nandu Patel & Andrew Blair: Why your investment portfolio should have genuine diversification

05 Feb 2018 Expert insight

Nandu Patel and Andrew Blair reflect on sensible and genuine diversification.

A property owner, doing well, with a number of houses in various cities may believe that he or she is adequately diversified. After all, if one of the homes develops a leak or subsidence, then it is unlikely that similar mishaps would occur throughout his or her portfolio. But what happens when the entire property market tumbles? Such is the brittle illusion of diversification – it’s easy to imagine we are diversified sensibly.

Nathan Mayer Rothschild (1777–1836) said: “It takes a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it.”

This is the situation in which many of our charity clients find themselves; they have significant investment portfolios that play a crucial part in helping to meet their spending needs. It is our job to ensure that they preserve and grow these portfolios through genuine diversification.

Why diversify at all?

First, let us explore the rationale for diversifying investments. To be sufficiently diversified means holding a variety of investments – to spread the risk. Therefore, if an event causes one or two of those investments to fail, it is hoped that other investments or assets in your portfolio may fare better and provide some protection.

There are two types of diversification to consider: protection against specific risk and protection against general risk. Specific risk refers to risk which may only affect a single company or at most a small group of companies. The shortcomings of one airline, for example, may also influence share prices in other aviation companies but not more widely. In contrast, general risk, such as inflation or a recession, is broader in reach and may affect whole markets or regions. This type of risk is almost impossible to predict and to completely avoid.

The philosophy that underpins spreading risk

The thinking and theory behind diversification and spreading risk has gained a great deal of traction since 1952, when the Nobel prize-winning economist Harry Markowitz first proposed what he labelled modern portfolio theory (MPT). Markowitz’s framework suggests that investment risk can be reduced by holding a diversified portfolio of asset classes and that to maximise a portfolio’s expected return, one should vary the proportions in the portfolio. The theory assumes that investors are naturally risk averse and will only take more risk if they are rewarded to do so.

Yet the concept of diversification has potentially been understood for much longer. As Markowitz himself pointed out in Shakespeare’s The Merchant of Venice, the merchant Antonio is quoted in the first scene as saying:

“My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year: Therefore my merchandise makes me not sad.”

While we agree with the principles of MPT when we are in a normal market environment, we are less convinced of its merits when markets are distressed. Further, the theory demands some pretty big assumptions. For example, it assumes that a truly risk-free rate of return exists and that investors are rational – mountains of evidence indicates that investors are quite the opposite.

We favour building portfolios from the bottom up, creating a balance of return and diversifying assets, rather than taking a more typically MPT-inspired top-down approach. Our view is that adding new asset classes doesn’t necessarily equate to more robust diversification. In fact, when equity markets are strained, many asset classes move in the same direction as equities. We only have to look back to the financial crisis of 2008 to witness a complete rout of most asset classes. So diversifying successfully is much more complicated to achieve than simply not putting all of our eggs in one basket.

Return assets centre on opportunities for growing capital, diversifying assets help preserve capital and offer some protection. In the following paragraphs, we look more closely at what we describe as diversifying assets and how they play their part in covering a range of potential outcomes. After all, successful investing over the long-term is more about avoiding disasters than delivering great results in any one year.

Managing risk

When investing, we are more interested in managing risk than measuring it to four decimal places. That is, while we accept that you can model risk to the nth degree, it is prudent to remain faithful to our primary investment objective: to preserve and grow the real value of our clients’ capital, while avoiding significant losses along the way.

This thinking informs our attitude towards capital loss and distils it into how much money could be lost and how long the loss lasts. We find it appropriate to further marshal these characteristics into what the financial writer and historian William Bernstein labelled shallow risk and deep risk.

Shallow risk keeps dedicated financial TV channels in business. It is risk that comes from regular swings in asset prices – for example, a share price fall following slightly disappointing quarterly results – and it involves a loss of capital that recovers anywhere from within several weeks to two or three years or longer. It may also be summoned by the tweets of world leaders.

Deep risk has much more profound consequences; it involves a permanent loss of real capital. This could arise from assets collapsing in value and never recovering, or an investment sold too soon after a share price fall, preventing the investor from benefiting from any subsequent price recovery. A persistent rise in inflation – left untamed – may also involve a significant loss of real purchasing power that could take decades to recover.

Naturally, we want to avoid deep risk and permanent loss. Yet we also seek to manage shallow risk appropriately; while it is not as serious, it can be troubling. And it pays to be mindful of an uncomfortable fact: most deep risk begins life looking shallow. To achieve consistent growth we can’t avoid the ordinary fluctuations of markets. Some risk is necessary. So as much as we methodically seek out suitable return assets, we apply the same precision in our distinctive – albeit uncomplicated – approach to diversification.

Introducing our diversifiers

Our diversifying assets fall under four categories: cash; bonds; portfolio protection; and alternative strategies.


We understand that when we hold cash, we come under close scrutiny. Clients sometimes wonder why they pay us a fee to hold what they can keep in a bank account. Yet cash gives us freedom; it allows us to make the most of good opportunities in the market when asset prices are depressed – particularly when panic sets in and it can be difficult to raise cash quickly. When assets become overpriced, cash can be an attractive holding, but when cheap assets are plentiful, it makes sense to target higher returns and move somewhere else.


Sometimes bonds produce attractive returns compared to equities – as seen in the years following the financial crisis when we were able to buy high yielding bonds at depressed prices and bonds behaved more like equities. Other bonds can provide a safe haven, such as shortdated government bonds (gilts) that, in fact, act more like a substitute for cash. If a bond neither acts as a diversifying nor return asset, we won’t hold it at all. Every position must earn its place in our portfolios.

Portfolio protection

At certain times we may incorporate equity put options in portfolios. These options perform well when equity markets are distressed and give us another chance to reduce losses in our portfolios. In many respects, put options are similar to insurance policies – we pay a premium to give us protection for a set period of time. We may pay this premium without receiving anything in return. But if an event that we ‘insure’ against does occur, then we generally get back many times the sum we paid for the initial premium. The cost of this insurance can vary widely. We exercise our judgement and buy such options when we feel that they are cheap. This tends to be the case after long periods of rising equity markets, with only modest setbacks.

Alternative strategies

One of the ways we aim to protect capital is through investing in funds run by specialist external managers. These managers aim to provide sources of return that don’t depend solely on rising equity markets. For instance, some may focus on identifying and profiting from macroeconomic events and themes, whereas others may look to benefit from persistent trends and patterns in financial markets.

Trends may become attractive due to how humans have evolved and now behave. It is not uncommon for markets to rise or fall based on what psychologists call herd behaviour – a tendency to copy others. If assets are rising people are inclined to buy, and when they fall they are persuaded to sell; these actions often ignore the fundamental strengths or weaknesses of an investment. Remember, we mentioned earlier how MPT assumes investors are rational.

Where appropriate, we will deploy a fund that uses a trend-following strategy. The advantage of such a fund is that it can perform well when equity markets are distressed as stronger trends emerge. Trend-following funds, therefore, provide another way to offer broad diversification, rather than perfect protection.

Preparing for unknown unknowns

While we act diligently when managing portfolios, we can’t guarantee complete capital protection. However, we anticipate that our diversifying assets should, over the long-term, perform well.

Our commitment to deep fundamental research helps us to systematically unearth the facts, whether they relate to our return or diversifying assets. Only by reading widely and assessing these facts carefully can we design our diversifying assets so we have cover for a range of unknown outcomes.

Of course, we don’t know what these unknowns will be, but it is prudent to be ready for what are called black swan events, a term popularised by finance professor and author Nassim Nicholas Taleb. These are unexpected events or occurrences which are unprecedented at the time. We should accept, nonetheless, that they may happen.

While we agree with the futility of trying to predict future events, we can assign a certain confidence that unpredictable incidents will occur – and plan accordingly. Rather than prepare for a particular outcome, we prefer to prepare for a range of outcomes.


The renowned investor (and co-founder of investment manager PIMCO) Bill Gross once said: “Good investment ideas should not be diversified away into meaningful oblivion.” While we agree with this to a point, charities should also be mindful of concentration risk resulting, potentially, in significant drawdown and permanent capital loss. Therefore we maintain that to preserve and grow capital requires both sensible and genuine long-term diversification.

Nandu Patel is head of charities and Andrew Blair is a director at Rothschild Private Wealth

Charity Finance wishes to thank Rothschild Private Wealth for its support with this article

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