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23 October 2017

Over the past week Australian shares were up 1.6% while small company shares rose 1.1%. Shares in developed countries were up 0.4% with the US market up 0.9%. Shares in emerging markets fell 0.6%. The Australian dollar lost 0.9% to 78.17 US cents. The Australian 10 year bond yield fell slightly to 2.78% with the US 10 year bond increasing to 2.38%. The oil price was little changed from a week earlier at 51.45 US dollars per barrel.

Rethinking diversification

Often when a situation involves choice and risk we hear ‘don’t put your eggs in one basket’. This is something we’re particularly mindful of when making investment decisions to manage your retirement savings.

To understand the meaning, it helps to consider situations in life where diversification, distributing eggs across several baskets, doesn’t offer any benefits and may well be dangerous.

Maintaining a relationship with a life partner is one instance where diversification is rarely useful. But here is another more contrived example.  Imagine you wash up on an uninhabited desert island, alone and almost without help. Almost, because on the island is a skeleton holding a note – the last written efforts of the previous inhabitant.  You kneel next to the discarded pen, retrieve the note and discover that the island has three wells; however, one of them is poisoned. And the poison kills instantly, even in microscopic quantities. Unfortunately, in his haste, the thoughtful author forgot to mention the location. What should you do for fresh water?

In this situation, recalling Uncle Phil’s famous adage, ‘don’t put all your eggs in one basket’, wouldn’t be helpful. In fact it would leave you scrambling for a pen to write an addition to the note.  The best strategy here would be to choose a single well and hope you’re lucky, perhaps the one furthest from the skeleton.  Of course, if there are animals on the island then some observation might help too.

So why are investments different? Imagine that in the example above we knew that diluting the poison further would result in a drink that could possibly make us unwell from time-to-time but wouldn’t be fatal. In this case Uncle Phil makes a good point; and his words of wisdom apply to investments too.

The risk or variability of returns decreases when we diversify, that is we invest across different assets. This is because when some assets go down others may go up.  The technical term for this relationship is known as ‘correlation’. Some assets are more correlated, they move together, and some are less correlated, they move more independently.

At Mine we use complex algorithms to understand these relationships and spend time considering the economics that drives asset prices.  We measure the benefits of diversification and continue to look for the best reward for risk.

Signing off

Sean Anthonisz | Senior Quantitative Analyst – Asset Allocation

Past performance isn't necessarily an indicator of future performance.

All data sourced from Bloomberg.