For financial professionals in the UK

Things aren’t always what they seem

8 Apr 2021

Diversification – by stock, sector, region and asset class – should be one of the abiding principles of the shrewd investor. It’s easier said than done however, with many markets and/or indices not nearly as diversified as they might at first appear. This article sets out some of the traps for the unwary.

People don’t always say what they mean
And things are not always what they seem
You better know before you make a scene
That things are not always what they seem
Lyrics by Sonic Underground

Widely known as the ‘father of value investing’, Benjamin Graham famously tells us: “Diversification is an established tenet of conservative investment.” The pivotal word in that well-known quotation is ‘conservative’, and it reinforces the fact that Graham’s abiding investment philosophy, first and foremost, was the preservation of capital. The ultimate aim of diversification is, needless to say, to reduce risk, ie the likelihood that an investment’s actual returns will diverge from its anticipated outcome.

‘Systematic’ risk – commonly referred to as ‘market’ risk – is largely undiversifiable in that it typically suffuses the entire investment landscape: interest rates, exchange rates, inflation, political uncertainty and war, or indeed a pandemic such as we’re currently experiencing, would be examples. The related risks can’t be mitigated, let alone eliminated, given that these factors are rarely associated with a specific region, industry, sector or business. Unsystematic risk is diversifiable, however, in that it is limited – either to a region, a nation, a sector, an industry or an individual company. In the quest for diversification of this form of risk, the well-advised approach is to invest in an array of assets such that they will not all be influenced by market factors in the same way, the expectation being that the positive performance of certain holdings will neutralise the negative performance of others. In short, it’s the practical application of the old adage ‘Don’t put all your eggs in one basket’ – but remember that the principle holds true only if the portfolio’s assets are not correlated, ie that they can be relied upon to respond differently, and often in opposing ways, to market influences and events.

This leads us neatly to a maxim coined in 1952 by another market luminary, Nobel prize-winning economist and the architect of modern portfolio theory Harry Markowitz – “Diversification is the only free lunch in investing”. He described it as such in that it facilitates the reduction of risk, at little or no marginal cost, whilst simultaneously maintaining or improving returns. Almost 70 years later, however, we’ve come to realise that a genuinely appetising free lunch requires a good menu, and that a great many investors are not nearly as diversified as they might think they are.

Diversification by stock

Investing in a single stock would seem to be a supreme example of folly – acute concentration of that kind leaves no margin for error – and so, for many UK domiciled equity investors, the FTSE 100 Index (or ‘Footsie’), launched in 1984, often represents a first port of call on their diversification journey. The index comprises the 100 largest companies by market capitalisation listed and traded on the main board of the London Stock Exchange, and therefore represents an advantageous basket of substantial and, in the main, high quality businesses. These established blue-chip firms tend to have a sizeable global footprint and run heavily internationalised operations, and those overseas earnings do provide an additional element of diversification – it’s estimated that circa 70% of FTSE 100 company revenues are generated overseas[1] – although that, in and of itself is a weak argument for neglecting overseas stocks in a portfolio. It also means that the Footsie, whilst arguably the most popular indicator for the health of UK PLC, may be a less reliable bellwether for the UK economy than many assume it to be.

While the FTSE 100 does offer exposure to all sectors, it’s clear that some are much more heavily weighted than others. The most conspicuous absentee is technology – companies in the tech sector make up circa 1% of the index, whilst they represent over 20% of the FTSE Global All Cap Index.3 By investing in the UK’s premier index market, one is effectively making a sizeable bet that tech as a sector will underperform whereas, in recent years, the reverse has been true … which goes some way towards explaining the relatively lethargic performance of UK equity markets.

Diversification by region

Assessing the issue logically, what is the likelihood that the businesses with the best performance potential just happen to be listed in the country where one lives? An investor moving from, say, the UK to France, would be ill-advised to sell all their FTSE 100 holdings and to reinvest the proceeds in the CAC, the French equivalent. The simple reality is that investing in one’s domestic market feels safer – we like to think we understand the companies in the local market better on the basis that we interact with them more frequently. The phenomenon is widely known as ‘home bias’. Limiting investments to a single country is a source of uncompensated risk however – one takes the additional risk, but without securing the potential for additional returns. Moreover, it’s a risk than can easily be mitigated through diversifying beyond one’s own geographical borders: location, location, location in other words.

An obvious solution is to consider an investment vehicle with a global investment mandate, with a benchmark such as the FTSE Global All Cap Index or the MSCI World Index. A closer look at the make-up of those indices raises some further diversification issues however, as can be seen in the charts below.

Source: FTSE Russell, FTSE Global All Cap Index, as at 31.03.21


Source: MSCI World Index, as at 31.03.21

A UK-only investor enjoys only a circa 4% exposure to world markets. By doing so, one is making an implicit bet that UK companies will perform better than those based in other territories – hence the appeal of a more internationally focused mandate. By investing on a globally benchmarked basis, with the potential to access 23 advanced economies and over 1,600 individual stocks in the case of MSCI World, one might conclude that excessive exposure to a single economy would be avoided. However, both benchmarks require the investor to be particularly bullish about the US, given that it represents well over 50% of the market capitalisation, and only one other country, Japan, represents more than 5% – rather less diversified than one might have suspected.

Diversification by sector

Whilst investing heavily in a single stock is demonstrably imprudent, investing in a single sector runs the risk of proving similarly unwise. Consider the battering now being felt by the global airline industry courtesy of the COVID-19 pandemic: shares in ICAG, the parent group of British Airways, were trading at above £6.70 as recently as mid-January 2020, but are now languishing at circa £1.95, a fall of some 70%. A great many other airlines, and also airline leasing firms, have similarly suffered, with the whole sector feeling the heat.

Investing on a multi-sector basis is much the better option therefore and so let’s consider a market like the US; as the largest economy in the world, one would imagine the opportunities for diversification are boundless.

Source: S&P Dow Jones Indices, based on GICS sectors, as at 31.03.21

Those investing in the US on a ‘benchmarked’ basis therefore need to be confident that the technology sector, for example, will outperform, given its weighting of over 25% of the index. Moreover, the three largest sectors collectively make up over half the index’s total value, and there is significant under-representation in sectors such as real estate or utilities.

Why it matters

Few would take issue with the fact that the arguments in favour of diversification when building an investment portfolio – by sector, by region and by asset class (this last aspect not touched upon in this piece) – are undeniably strong. As ever in life, the devil is in the details however and, having determined what one wants to achieve by way of a diversification strategy, it’s important to look closely at how that goal can best be achieved. Failure to do so may mean that free lunch leaves a bad, and lingering, taste in your mouth.

[1]Source: Interactive Investor, 25.08.21
[2]Source: FTSE Russell, FTSE 100 Index, as at 31.03.21
[3]Source: FTSE Russell, FTSE Global All Cap Index, as at 31.03.21
[4]Source: AJ Bell, Dividend Dashboard Q4 2020
[5]Source: MSCI World Index, as at 31.03.21
[6]Source: S&P Dow Jones Indices, based on GICS sectors, as at 31.03.21 Benchmark
A standard against which a portfolio’s performance can be measured. For example, the performance of a UK equity fund may be benchmarked against a market index such as the FTSE 100, which represents the 100 largest companies listed on the London Stock Exchange. A benchmark is often called an index. Bullish/Bull market
A financial market in which the prices of securities are rising, especially over a long time. The opposite of a bear market. Diversification
A way of spreading risk by mixing different types of assets/asset classes in a portfolio. It is based on the assumption that the prices of the different assets will behave differently in a given scenario. Assets with low correlation should provide the most diversification. Market capitalisation
The total market value of a company’s issued shares. It is calculated by multiplying the number of shares in issue by the current price of the shares. The figure is used to determine a company’s size, and is often abbreviated to ‘market cap’. Systemic risk
The risk of a critical or harmful change in the financial system as a whole, which would affect all markets and asset classes.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.


Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.


The information in this article does not qualify as an investment recommendation.


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