Just as a basketball coach relies on their playbook to navigate high-pressure moments, this column explores the frameworks, principles and behaviours that help investors make better decisions in their investment journey.

Most investors understand the concept of diversification. It’s one of the first investing lessons we’re taught. As the old adage goes, don’t put all your eggs in one basket.

Many investors believe they’ve followed that advice. After all, they may own dozens of shares, ETFs and managed funds. Yet despite the growing number of investments in many portfolios, the underlying sources of risk are often far less diverse than they appear.

That’s not necessarily the investor’s fault. It’s increasingly a feature of modern markets.

Achieving optimal portfolio is more difficult in concentrated markets. While investors can easily identify obvious concentrations, such as heavy exposure to the handful of mega-cap technology companies benefiting from the AI boom, the bigger challenge often lies beneath the surface.

Investments that appear uncorrelated on paper can be exposed to many of the same economic drivers, market themes and sources of return. The result is that investors may be carrying far more concentration risk than they realise.

Identifying those hidden concentrations can be what separates a resilient portfolio from a vulnerable one. And as markets become increasingly interconnected, that task is becoming more important than ever.

The golden age of diversification

Diversification has been a cornerstone of investment theory for decades.

American economist Harry Markowitz transformed what had previously been viewed as common sense into a mathematical framework. His 1952 paper “Portfolio Selection”, which later earned him the Nobel Prize, demonstrated that evaluating an investment in isolation ignores how it interacts with the rest of a portfolio.

A portfolio of assets that behave differently in changing economic environments can deliver a superior balance of risk and return than any individual investment on its own.

Subsequent research found the benefits of optimal diversification extend beyond individual shares.

Diversification can be achieved through different sectors, countries and asset classes.

Markowitz’s work led to diversification being labelled the only “free lunch” in investing. Yet, like all free lunches, the cost eventually became apparent. The benefits still exist but they aren’t as easy to capture today.

While the theory of diversification has stood the test of time, markets have changed.

The diversification benefits identified by Markowitz were developed in the age of scarce access to global markets where asset classes historically moved more independently of one another.

Continued globalisation and deeper market integration have increased correlations across markets and asset classes. Finding investments that genuinely offer different sources of return is becoming increasingly difficult.

Why diversification has become harder

Over the past several decades, building a diversified portfolio was relatively straightforward.

Investors could combine Australian shares, international shares, property and bonds, with the expectation that weakness in one area would be offset by strength in another.

Today, that picture is becoming less clear.

The most visible challenge is the growing concentration within global sharemarkets. A handful of mega-cap technology companies have driven a significant share of recent market returns. This has left many investors more exposed to the artificial intelligence theme than they realise.

But the problem extends beyond equities.

Increasingly, assets that were once relied upon to provide diversification are moving in the same direction. International shares, listed property, hedge funds and even bonds have become more closely tied to the fortunes of the broader market.

As Chad Padowitz, Co-CIO of Talaria Capital, recently observed, more than 90% of the world’s investable assets now move in line with the S&P 500. In his view, investors face a new diversification challenge: “What do you do with one basket and one very big egg?”

Based on their findings, on a scale where 1.0 means moving in lockstep with the S&P 500, developed market equities (ex. US) have gone from a correlation of 0.46 in 1995 to 0.79 today. Listed property has gone from 0.61 to 0.82.

Even hedge funds, which institutional investors used to provide differentiated sources of return, now sit at 0.81.

The implication is that many portfolios may be less diversified than they appear. Investors often assume that owning multiple funds, asset classes or investment strategies automatically reduces risk.

Yet if those assets are ultimately being driven by the same economic forces, the diversification benefits may be far smaller than expected.

Diversification has always depended on owning assets with different drivers of return. As correlations rise across markets, finding those genuinely independent sources of return becomes increasingly difficult.

Aussie investors face a two-fold challenge

Australian investors face an additional hurdle.

For context, in the decades following World War II, industrial and financial companies formed the backbone of the Aussie sharemarket. The mining boom of the late 1960s and 1970s cemented resources as another major pillar of our market.

Together these developments helped shape the modern ASX. Today, financials and resources account for a significant share of the Aussie sharemarket. The implication is that many investors begin with a concentrated portfolio before adding a single international holding.

This concentration can be amplified when investors attempt to diversify. Adding managed funds, ETFs or active managers may increase the number of holdings.

However, it doesn’t necessarily change the underlying exposures. Many Australian equity funds ultimately own many of the same banks, miners and large-cap shares that dominate the broader market.

The result is a two-fold challenge for the everyday Aussie investor. Investors must navigate the growing concentration within global markets while also avoiding the structural concentration embedded in the Australian market itself.

What genuine diversification looks like

The uncomfortable reality for investors is that genuine diversification may be far scarcer than it once was.

This doesn’t mean diversification is dead. It means investors need to look beyond asset labels and focus on the underlying drivers of return.

That requires understanding what is driving portfolio performance. If multiple holdings depend on continued AI enthusiasm, falling interest rates, strong economic growth or rising asset prices, investors may be making the same bet repeatedly through different vehicles.

True diversification exists where return drivers are genuinely different.

Consider five investments: an Australian bank, a global healthcare company, a government bond, a physical Gold ETF and a listed infrastructure share. Each is exposed to a unique set of forces.

Banks tend to benefit from healthy economic growth, strong credit demand and stable financial conditions. For example, the performance of the big four banks in Australia is closely tied to the health of our economy and the willingness of households and businesses to borrow and spend.

Healthcare companies are often driven more by demographics, innovation and demand for essential services. A global healthcare company may benefit from ageing populations, rising healthcare spending and continued demand for medical treatments in a developed country.

Government bonds have historically provided a flight to safety during periods of economic weakness or market stress. When economic growth deteriorates, investors often seek more defensive assets and central banks like the RBA typically cut interest rates. Lower rates increase bond prices. At the same time, equity values typically fall.

Gold is another example of an asset with historically low correlation with other asset classes. The gold price is driven by demand from central banks, jewellers, technology companies and ETF inflows. In a market downturn, investors use gold exposure as a store of value in inflationary environments.

Infrastructure assets can benefit from long-term contracted revenues and in some cases inflation-linked cash flows. A good example on the ASX would be Transurban (ASX.TCL). Toll road operators are typically good inflation hedges as toll revenues contractually increase over time while demand for key transport links is less sensitive to economic fluctuations.

This is not a shopping list of assets for your portfolio. The point I am making is that these investments succeed for different reasons. When one faces headwinds, another may be supported by an entirely different set of economic conditions, reducing the portfolio’s dependence on any single theme, sector or market outcome.

In an environment where more assets are correlated and market leadership is increasingly concentrated, diversification deserves to be treated as a scarce resource rather than a box-ticking exercise.

The bottom line

The greatest diversification challenge is not finding different investments. It is finding investments that genuinely behave differently when it matters most.

Because the purpose of diversification isn’t to maximise returns when one theme dominates markets. It’s to ensure your financial future doesn’t depend on a single theme, sector or narrative proving correct.

Subscribe to get Tyger’s insights in your inbox