Investors are constantly told to diversify. Perhaps no investment advice is more ubiquitous than the admonition not to put all of one’s eggs in one basket. But what does diversification look like? How can we measure it, and what are the consequences of neglecting it?
In 2017, we wrote a blog post explaining how diversification helps mitigate the idiosyncratic risk of investments. We showed that liwwa investors whose portfolios had a larger number of “effective loans” -- or loans adjusted for relative size -- had enjoyed more stable and predictable returns.
Today, three years later, we are happy to note that liwwa’s investors are more diversified than ever. The average liwwa investor has a portfolio of 16 effective loans, and many hold more than 50. The distribution of effective loans in liwwa portfolios is illustrated in the chart below.
If we plot the effective number of loans in these portfolios against their investment returns, we see a clear pattern: diversified portfolios have their returns clustered tightly around the expected long-run average, while less diversified portfolios are widely scattered.
Investor portfolios with fewer than 10 effective loans have relatively unpredictable returns. Overall, while this group saw high average IRRs of around 12%, the standard deviation of returns for this group was 7.5 percentage points. A small share of these undiversified portfolios -- 3.9% -- even saw negative overall returns.
By comparison, portfolios with more than 10 effective loans had about the same average IRR -- around 14% -- but much less volatility, with a standard deviation of only 2.5 percentage points. All portfolios with more than 8 effective loans saw positive returns.
This demonstrates the importance for investors of spreading their portfolios across many different assets to ensure their returns are predictable. In particular, liwwa investors should aim to have more than 10 effective loans in their portfolios to reduce the uncertainty of their returns. An even higher number would be strongly preferable.
For readers interested in learning more about what we mean by “effective number of loans”, and how this metric is calculated, we recommend reading our original blog post on this topic from 2017.