One of the most striking recollections of interviewing Professor William Sharpe at his home in Carmel, California, for our documentary Passive Investing: The Evidence was his emphatic response when asked to give his golden rules for successful investing.
“The three most important things,” said the Nobel Prize-winning economist, without a hint of hesitation, “are diversify, diversify, diversify.”
There must be very few people in the world who would claim to know more about asset pricing than Professor Sharpe. Yet, just at the moment, there are plenty of self-styled experts who seem only too keen to jettison his advice.
Laith Khalaf, of Hargreaves Lansdown, for example, recently told The Telegraph, that young people saving for retirement should invest exclusively in shares - either in a “strongly performing investment fund” or a UK tracker fund. Full marks for advocating a tracker. But 100% equities? And 100% UK? Steady on.
Patrick Connolly of Chase de Vere was similarly bullish, pointing out - rightly of course - that savers in their twenties have plenty of time to ride out any volatility in the stock market.
It fell to Brian Hill, a financial adviser at Jones Hill, to redress the balance of The Telegraph’s article.
“I think having more than 85% of your workplace pension in funds that buy shares is extremely dangerous, as stock markets are susceptible to sharp falls," said Hill.
“Pension saving is like having a balanced diet, and by investing in a mixture of assets, including bonds and property, you will over the long run produce smoother and better returns.”
For every Brian Hill right now, there seem to be several Khalafs and Connollys. Now is the perfect time to invest in equities, we keep being told; after all, some argue, 2013 proves that “diversification doesn’t work”.
Last year, it’s true, was an excellent year for shares - especially US equities. And yes, if the object of diversifying across different geographical regions and different asset classes was to produce higher returns, then no, it didn’t work.
But, of course, that is simply not the point. Diversification is not about picking winners or maximising short-term returns.
As Chuck Jaffe put it in a recent blog, “Think of it [diversification] like putting a sound, solid roof over your financial home. You can’t argue that roof has no value - compared with someone else living with leaky thinking - just because the sun is shining; the sun won’t shine forever.”
Congratulations to those who staked everything on US equities 12 months ago; there can’t have been many of them, and those who did advocate that approach certainly didn't shout very loudly about it. But history shows that ploughing everything in to last year’s top performer - forgetting the leaky roof and hoping the sun keeps shining - can be very risky. It’s far better, as an investor, to be broadly right than completely wrong.
Much as the experts like to imply they know what lies around the corner, the truth is that nobody does. The times when diversification really comes into its own are periods of unexpected upheaval. Another lesson of history is that such events come rather more frequently than some of us would like, and often completely out of the blue.
Yes, if you’re young, and retirement is another 30 or 40 years away, you should of course invest primarily in equities. But ignore Professor Sharpe’s advice at your peril. No matter how lucky you feel, putting all your eggs in one basket never was a good idea.
Image copyright Kate Hiscock