The phrase, ‘don’t put all your eggs in one basket’ encapsulates the principle of diversification – a concept which long predates this quote originally attributed to the writer of Don Quixote in 1605. Indeed, for centuries before the academic Harry Markowitz formalised Modern Portfolio Theory in 1952 (for which he was later awarded the Nobel Prize) stating that ‘portfolio diversification is the only free lunch in investing’, diversification has been a core tenet of investment, and of leading investors.

Today, investors are confronted with a complex backdrop – with questions from how artificial intelligence will reshape the workplace to what business models will be adversely impacted by climate change. Moreover, the concentration of global equity markets has reached a historically high level, with the US market comprising over
70%¹ of developed market indices and, within the US, the Magnificent Seven accounting for almost a third of that market.

While this presents a challenge to achieving a well-diversified portfolio for investors, we believe that our globally diversified approach is more relevant today than it has ever been.

Diversification reduces volatility and timing risks
From an investment perspective, it can be challenging to assess the permanence of prevailing trends, and to determine their implications on prospective returns. An undiversified investor who mistakes cyclical change for secular can end up being thrown off course. A good example of this was the investment experience during
Covid. Covid had a profound impact globally in ways that none of us had ever experienced before. Policymakers had never had to contend with this type of challenge, and corporates similarly were in completely uncharted territory.

But much of the social change seen during 2020 and 2021 provides an excellent example of how corporates and investors can confuse short-term disruption with permanent change. The duration of change is often highly uncertain.

If one thinks about an event like Covid, investors assessed impacted winners and losers. Investors will look for companies with the greatest exposure to the theme and, in this example, the vaccine makers had the closest link to this trend. They were perceived as the solution to a problem which was Covid. Commercialising that solution
led to tremendous gains for some of the pharmaceutical companies who helped in the creation and manufacture of vaccines.

However, after strong gains during the dark days of Covid, Pfizer’s² share price has fallen by around 50%, while rival Moderna’s is down by over 90%. Outside some of these vaccine makers, investors considered the impact of Covid as a catalyst for social change. Working from home, exercising from home, eating takeaways more often – the shares of companies exposed to people spending more time at home all boomed.

Some of the most prominent winners from the lockdowns in 2020 were the likes of Peloton – on the assumption that exercising at home would replace visits to the gym. Zoom, the videoconferencing company, was another winner, as investors assumed remote working would boost profits.

And many investors bought these stocks, either confusing a transient trend with a permanent change, or wrongly extrapolating a short-term spike in demand into a structural change in market size for the product. This behavioural tendency to misjudge the permanence of trends is well explained by Kahneman & Tversky (1979),
whose Prospect Theory highlights how investors often overreact to short-term events. Back in 2020 it was very difficult to discern what social changes would be permanent, and which would be temporary or, indeed, even when changes were temporary, what the wider and longer lasting impact would be.

For example, Zoom gained by 765% in 2020 but is down by 80% since then, while Peloton has declined by a staggering 95%³. So, as investors, it is important to assess whether change will be permanent or not. Similarly, the price which one pays for future hope is an important consideration in terms of an investment thesis. Working from home is far more common now than it was pre-pandemic, but many trends associated with Covid have proven to be temporary, rather than permanent, in nature. Diversification helps to mitigate overexposure to transient themes or trends and helps to avoid pockets of investment excess.

A diversified approach is more likely to include the ‘winners’
There has been well publicised work on ‘skew’ in the stock market (Bessembinder, 2018) which suggests that only a tiny subset of around 4% of US companies are responsible for all the investment returns. Indeed, between 1926 and 2016 more than half of US stocks actually lost money or did worse than short-dated treasuries – which is the equivalent of cash. Figures were even more pronounced in global markets with 61% of companies losing money relative to cash and only 1% of companies driving index returns.

If only we could identify those small number of high returning companies in advance, representing 1-4% of the market, we could forget about the rest which add little value or destroy value for shareholders.

Of course, F&C were fortunate – or skilled – to invest in Amazon in 2006 as a $10bn company – now worth around $2.5trn, and a one-year-old firm called Facebook in 2005 when it was a private company worth only $100m, which is now worth around $2trn.

But these companies are the proverbial needles in the haystack. Should investors search for the needles – investing in a highly concentrated portfolio of stocks – or should you just buy the haystack – buying the market index, knowing that the needles are in there somewhere?

It is easy to take an extreme view: highly active, searching for the small proportion of companies which will grow to multiples of their current size. Or, alternatively, opt for a fully passive strategy: just buy the whole index. For those who favour the former, the results of Prof. Bessembinder’s analysis unfortunately suggest that the average concentrated portfolio will underperform the market.

In our view, as is often the case, the best approach lies somewhere in-between these two extremes. F&C’s approach is to employ skilled managers to scour a section of the market – or haystack – but we diversify across a number of these different approaches and areas of the market. The simple point is to try and provide more exposure to the future winners and, as far as possible, avoid the numerous losers. A diversified approach investing across multiple focussed strategies is more likely to capture the future winners in the market, which we know account for a disproportionate amount of total return.

A diversified approach focuses on spending risk efficiently
On the point of concentrated portfolios, such offerings are demonstrably different than commoditised, passive offerings, which track the index. Arguments are frequently made that an investor need only hold a small number of stocks to deliver returns which are akin to that of the wider index and that holding more than a small number of companies will result in ‘diworsification’ as the manager holds stocks in which they have lower conviction and which dilute from their ‘high conviction’ picks.

While a relatively low number of stocks, in combination, can reduce absolute risk, investors will likely retain reasonable risk relative to market indices from highly concentrated portfolios. In other words, concentrated portfolios do not increase the likelihood of outperforming a market index. Rather, concentrated portfolios have a greater likelihood of delivering a return which differs from the index – positively or negatively. Some have promoted the work of academics (Cremers and Petajisto, 2009 and Petajisto, 2013) to advance the notion that the more active an approach, through concentration of holdings or active share, is more likely it is to outperform. Subsequent work (AQR, 2016) has debunked this supportive conclusion, however, and reaches the more logical observation that high active risk is no meaningful predictor of positive excess returns. Indeed, risk should be spent on investments where there is likely to be an accompanying ‘reward,’ in return terms.

Our approach to diversification recognises that blending focussed strategies, invested by skilful managers with a clear mandate, will allow us to own a collectively diversified range of best-in-class companies while avoiding ‘unrewarded’ risks.

Focus on rewarded risks
For many investors, including the professionals, it is tempting to conclude that a highly performing specialist manager will have delivered those superior returns through skill, but studies have shown that much of the returns tend to be dominated by the decision over which part of the investment haystack they choose to search, or to make another analogy, which part of the pond they choose to fish. In other words, whether an investor prioritises ‘growth,’ ‘value,’ or ‘quality’, and how they manage those potentially competing objectives.

Even the most revered of investors, such as Warren Buffett, have had their investment returns decomposed (AQR, 2019) into constituent components. It has been demonstrated that even the very best investors have made a very substantial part of their returns through the manner, or style, by which they invest. Warren Buffett chose to select cheap, high-quality stocks, and his access to cheap leverage to amplify returns explains a large part of his extraordinary rates of return. This in no way denigrates the delivered results. Rather, the prior identification of this approach as a strategy, the consistency of execution, and the commercial exploitation of these results, marks Buffett as perhaps the greatest living investor.

F&C’s philosophy is to invest in high quality managers who look for needles in different haystacks. By combining investments in ‘growth’, ‘quality’, and ‘value’ we diversify the portfolio across rewarded risks, whilst identifying future winners that can generate strong returns.

Diversification for today’s world
This principle of diversifying exposure across a range of investments for F&C has ensured a robust underlying portfolio which has stood the test of time across various market cycles and economic conditions. It has also enabled F&C to pay a dividend to shareholders in every single year since 1868. We believe our principles of diversification allow us to generate excess returns over the long term.

First, to beat the market index you cannot look like the index. Concentrated portfolios, containing holdings (public and private) selected by skilled managers will provide return streams which differ from that of the index. Second, returns from those strategies will have a large component which is driven by the stylistic approach of the
manager. There is more than one way to win in investing, and clearly defined approaches to growth (or momentum), value, and quality all have been proven to deliver positive excess returns over the market in the long run. Third, blending across these different styles, globally and regionally, helps to reduce the inherent risk of trying to time investments into areas which are in vogue. Appropriately managed, it should also increase the chances of exposure to the small number of stocks which drive overall returns, while minimising exposure to losing stocks.

Within F&C’s portfolio, our philosophy of blending different investment strategies allows us to own high conviction ideas from different segments of the market. As an example, in 2024, both our US value and growth managers identified investments well positioned to benefit from the increased demand for artificial intelligence. Our valueorientated manager identified Vertiv, a provider of power systems, monitoring equipment, and cooling solutions for data centres, while our growth-orientated manager owned Nvidia, a designer and manufacturer of graphic processing units. Over the year, both companies posted strong performance, with Vertiv returning over 130%, and Nvidia returning over 170%.

A proof statement for diversification
F&C’s principles have adapted through time, but diversification has long been a hallmark. It has enabled us to not only survive but to thrive for over 150 years. Significant strategic decisions in our asset mix have also contributed meaningfully to our shareholder returns, such as the decision to invest almost all our assets into listed and private equities in the 1960s. Our approach has proven successful.

Today the portfolio is diversified across countries, sectors, investment approaches as well as both public and private equity. This diversification means that our returns are unlikely to top the performance charts one year, nor be bottom of the leaderboard the next. But our consistent approach has delivered spectacular returns for shareholders in the long run. £100 invested at launch in 1868 would now be worth over £24m, well ahead of inflation of £15,000. More recently, at the end of 2024, our consistent returns were evident with our NAV returns exceeding those of the market benchmark over 1/3/5/10 and 20-years and, uniquely amongst competitors, both NAV and shareholder returns exceeded those of the open- and closed-ended peer group over all of these time periods. Investment trends will ebb and flow but the fundamental rules of investment are constant – diversification matters.