The investing question that many don’t ask

You could probably fill a decent-sized library with all the words that have been written about investment over the years.

Most readers of this column know the basics — even if they don’t all apply them to their investment decisions.

Price-to earnings (P/E) ratios, dividend yields, five-year or ten-year compound annual growth rates, cash flows, price-to-earnings-growth (PEG) ratios, gearing: these are the vocabulary of investment decisions.

And such metrics most definitely aren’t wrong — even if they sometimes provide investors with a greater sense of certainty than is really warranted.

You have to start somewhere, and those are undeniably numbers that matter.

Strategy, not selection

But there’s another question that also matters, and it’s one that I rarely hear being asked.

There is, I think, a reason for this. And it’s a reason that comes back to that comforting — if sometimes spurious — sense of assurance that numbers such as dividend yields and P/E ratios provide.

For the question to which I’m referring doesn’t have a number as an answer. The response comes in the form of a ‘yes’, or a ‘no’, or sometimes possibly a ‘maybe’, when asked when you’re considering buying a particular share.

Put another way, it’s a question that’s more to do with investment strategy, rather than the fundamentals of stock selection.

So what is this question, then?

Free lunch

Quite simply, it’s this:

“Will buying this share usefully increase my diversification?”

I know, I know.

I’ve written about diversification before, from time to time.

Yet huge numbers of investors aren’t adequately diversified — or even, often, really diversified at all.

Many, I know, rarely fish outside the waters of the FTSE 100 — the London stock market’s hundred largest shares. Some focus even more tightly, restricting themselves to those big consumer-facing shares with familiar names — companies such as HSBC, Tesco, Shell, GSK, Unilever, and British American Tobacco.

Diversified? Hardly. Which is a shame, because diversification can powerfully enhance returns, while reducing risk. Nobel Prize laureate Harry Markowitz, no less, famously remarked that “diversification is the only free lunch” in investing.

Stock diversification: an easy win

There are many facets to diversification — bonds, gilts, stocks, property, gold, cash: each arguably has attractions from a diversification point of view.

But there are also problems and challenges from a liquidity and practicality point of view. Even buying a small buy-to-let apartment costs a fair amount of money, for instance – you can’t buy one-tenth of an apartment, or a fraction of a house. Gold requires safe storage, and doesn’t earn an income. Cash depreciates in inflationary times. Bonds and gilts aren’t always the most accessible things for investors to get their heads around.

Restricting the consideration of diversification solely to stocks considerably simplifies matters, as well as lowering the liquidity barrier as well as making it more practical to implement.

Different sectors, different countries

And if we’re solely talking about stocks, then two areas of diversification that matter most, I think, can be summed up as sectoral diversification, and geographic diversification.

Both are straightforward. Sectoral diversification is about the sector, or industry, in which a given business operates. Geographic diversification is about broadening your investment horizons geographically — Europe, Asia, North America and so on.

Both are good. And the beauty of geographical diversification is that often it throws in sectoral diversification as a bonus. America, for instance, has technology giants — think Alphabet, owner of Google, Microsoft, Meta (owner of Facebook), Apple, and Nvidia — that are difficult to replicate with a purely UK focus.

Asia and Europe, in turn, provide their own opportunities for additional sectoral diversification.

London is just 3%

Europe makes up just 11% of the global equity market. America, 43%. Japan, 5%. Hong Kong, 4%. And the UK? Just 3%.

So a focus on a handful of shares from the FTSE 100 is a focus on a few of the largest shares in that 3%.

Which, when you think about it, isn’t really diversified at all.

So always think about asking yourself: if I buy this share, will it add an industry or sector that I don’t already hold? And if I buy this share, will it add to — or reduce — my geographic diversification?

Remember, it’s the only free lunch in investing.