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A Startling Example of the Benefits of Diversification in the Stock Market

It's a time honoured rule that you need to diversify in the stock markets, and the following examples offer proof of the wisdom of that rule.

Table of Stock Returns 1

The rational for this is well understood. Businesses change shape, industries die off, new ones emerge. Business is dynamic and is ever changing and the risks change over time.

A quick look at the period covering the global credit crisis makes the argument in favour of diversifying very well.

The table opposite highlights the performance of a portfolio of just six holdings from the peak in the Irish equity market on 1st Feb 2007 to the close of business at the 9th November 2013.

While Allied Irish Banks went bust, and is effectively down 100%, the performance of the overall portfolio is up 30%, excluding dividend income. In Ryanair's case, dividend income was significant as the group paid a few special dividends over the period.

Owning the banks in Ireland through the global credit crisis was a catastrophe. However, had you spread your monies across just six different holdings ensuring sector diversification and just one alternative asset class (gold) you survived the worst bear market in 70 years.

Table of Returns 2

The next table makes the same point in a more dramatic way. Owning just one stock, a bank, resulted in a 100% loss. There's no recovering from that.

By adding in a second stock, CRH, which is also still down 35% since 1st Feb 2007, the combined holdings have resulted in a loss of 67%. Adding in a third stock, DCC, reduces the portfolio loss to 19%. Adding in a fourth stock, Kerry, swings the portfolio into profit with a gain of 19%.

Adding in a fifth stock, Ryanair, makes little difference. But adding in one other asset class, gold, brings the gain to 30%.

So, just six holdings across different sectors of business and one alternative asset class moved an investor from a 100% loss to a 30% gain. I think the benefits of diversification, in terms of avoiding the risks of a total loss of capital, are well made with this simple example of a six stock portfolio.

The Chart below makes a separate point. Following a severe setback in markets it often takes time for markets to recover. Diversification may not appear to assist you in the teeth of the downturn.

Chart of diversification Returns

But as the economic crisis passes and corporate earnings and economies start to recover, companies that were not mortally wounded by too much debt or extreme overvaluation at the outset started a gradual recovery.

Indeed, in the case of DCC, Kerry and Gold the prices have gone on to new all-time highs.

Near the bottom of the market in Feb 2009, the value of a €10,000 investment in such a portfolio had declined by 34%. Losses were greater in the stocks but a positive performance by gold kept the losses to 34%.

It wasn't until Feb 2012 that the overall portfolio was back in positive territory with a 7% gain.

By Nov 2013, the portfolio has gained 30% excluding dividend income, which in Ryanair's case was significant as it paid hefty 'special dividends' over the period.

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Rory Gillen
Founder
GillenMarkets