Diversification – Don’t Leave Home Without It

Insurance and portfolio management have a lot more in common than most people think.

Imagine for a moment that you own an insurance company and your entire portfolio is made up of ten very big policies, all paying you healthy premiums.  Also imagine that you know a lot about your insured policy holders, and you feel confident about each policy.

But, being a responsible person, you hire an actuary to take a look at your risks.  After careful examination, the actuary comes to you in a panic.

“You’ve got a big problem” he says.  “A few of those claims going wrong could really hurt you.”

Then he adds some grist to his words.  “You only have a small number of large policies.  Most of the insured risks are from the same area and it is possible one big event could affect multiple claimants at once.  In other words, the risks between policies are correlated.”

“Correlated?” you say.

“Yes,” he responds, “It means that a risk affecting one can affect others.  The problem for you is that one rare event could bring this company down.”

It’s clear you’re unimpressed.  The actuary continues, undeterred.

“Your portfolio of policies is completely under diversified, breaking the first rule of risk management.  Let me put it this way – you could make a killing, get average results or get killed.  But the chances of getting killed are way too high!”

You don’t like the sound of getting killed.  “What’s the solution?” you ask.

The actuary responds, “Obviously, you need more policies; smaller policies, from more locations with different and less correlated risks.”

This story isn’t just hypothetical.  In 2011 AMI Insurance held 35% of the market share in fire and general insurance in Christchurch. Clearly, the risks on those policies were correlated, in so far as one event affected nearly all policy holders at the same time.  AMI had the audacity to allude to the fact that they were victims of their own success…but equally they were victims of their own hubris regarding risk control.

What’s the connection to a portfolio of investments?

Well there is quite a strong connection if your share portfolio includes only a dozen or so New Zealand shares and a few from Australia.  A portfolio concentrated in such a way is susceptible to two big risks:

  1. A sudden reversal in the fortunes and price of any one business you own.
  2. Something happening in New Zealand that seriously affects the profitability of all businesses in this country (they’re called recessions).

Like an insurance company that wants to control risk, you don’t want a few huge holdings.  You want thousands of small holdings (shares) in your portfolio, across dozens of countries and hundreds of different industries.

This is exactly what a diversified asset class portfolio offers.

You know that some of those businesses will fail or deliver very poor returns, but it doesn’t matter, because any one company is only a miniscule part of your portfolio.

Similarly, an insurance company with a diversified group of policies understands that someone will make a claim, and they have spread the risk of that eventuality so that the impact will be minimal.

This approach, while making perfect sense from a risk perspective, has one important drawback.  Whilst it removes the chance that your portfolio will get ‘wiped out’ by some inevitable poor returns, it simultaneously removes the chance that you will make a killing.

It essentially destroys the potential of a get rich quick event, but if that’s your game, why have a dozen or so shares?  Just pick your favourite one and pray…
Of course you wouldn’t insure your home with a company that had such a foolish strategy.  Why would you insure your future that way?

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