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What is theYour browser does not support the element. best piece of investment advice you could fit into a single, short sentence? “Buy stocks” wins points for brevity and high returns. “Buy American stocks”, if given at almost any point over the past few decades, would have done even better. “Don’t waste money on stockpickers’ fees” deserves an honourable mention. Here is a less punchy suggestion: “A diversified portfolio can have the same returns as a concentrated one, with less risk.”Diversification is such an important idea in modern finance that it is easy to forget its age. The economist it is most associated with is Harry Markowitz, who won a Nobel prize for setting out its maths in the 1950s. But the practice, if not the theory, was popular long before that. During the first heyday of financial globalisation, in the early 20th century, European investors could hardly get enough of foreign assets. A survey by Charles Conant, a journalist, published in 1908 estimated that between a quarter and a half of the average British portfolio was invested abroad. In French and German portfolios, overseas allocations were around a third and a half, respectively. Such cosmopolitanism was then shattered by war, hyperinflation, capital controls and the Depression.More than a century on, and despite present-day worries of financial fragmentation, holding a varied portfolio is easier than ever. Foreign assets can be bought at the tap of a trading app, while cheap index funds give investors instant exposure to thousands of stocks in dozens of countries. The idea of diversifying across asset classes as well as geographies—via the classic 60/40 portfolio of stocks and bonds, for instance—is firmly in the mainstream. More exotic choices such as commodities and cryptocurrencies have become more accessible to retail investors, too, and private assets may eventually follow suit.Unfortunately there is a catch, and it is a big one. Building a portfolio that looks diversified has become a cinch. Building one that is actually diversified, in the sense that its components offset each other’s risk, has become much harder.Diversification gets its magic from the fact that the prices of different assets do not all move together. The market values of a gold mine in Kazakhstan and a recruitment firm in San Francisco, for instance, will fluctuate for very different reasons even if they both have similar returns. Hold shares in both and there is a chance that a sharp drop in one will be cushioned by a rise in the other. Hold lots of uncorrelated assets and you get this effect writ large: a portfolio with a return that is the average of its constituents’ but with a lower volatility. The less correlated the assets’ returns, the greater the magic.Yet just as it has become easier to invest in a wide array of assets, the correlations between them have shot up. These are measured on a scale from -1 to 1. A pair of prices that always move in opposite directions—in other words, a diversifier’s dream—scores -1. Prices that move in lockstep, offering no diversification benefit, score 1. In the 1970s, before the re-globalisation of finance gathered pace, the average correlation between pairs of share indices for developed markets was 0.37. By 2021 it was 0.75. For pairs of emerging-market indices the average correlation rose from 0.05 to 0.49. As the barriers separating them have come down, markets that once moved almost independently now increasingly ebb and flow together.It seems, therefore, that geographical diversification has followed a trajectory which is wearily familiar to financial historians. When few investors could manage the trick, it was a stellar idea. Once it was popular and available to the mass market, its dynamics were distorted and the benefits started to fade. A similar fate befell the Buffettian strategy of buying undervalued “cigar-butt” stocks, after automated screening made them easy to identify and hence vanishingly rare. In the case of diversification, once investors started spreading their capital across stockmarkets, they all began to resemble each other.What stings even more is that diversification across asset classes has become more difficult, too. Between 2000 and 2021 stocks and bonds listed in America complemented each other excellently, with an average correlation of -0.29. Since 2022, when both crashed together, that has risen to around 0.7. There is still some benefit to spreading your portfolio across different regions and asset classes. But given the gains have shrunk so much, it is no wonder investors are chasing after ever more esoteric products.
