Taking stock - does diversification work?

Former investment banker Russell Taylor asks if recent history shows that portfolio diversification helps investors

Those brave enough to invest after the financial panic of last autumn, and the economic collapse that followed, have done well. Commodity prices have boomed while the stock market indices of the BRIC emerging market giants (Brazil, China, India and Russia) have, in some cases, doubled. Politicians and stock market analysts see the green shoots of economic recovery sprouting everywhere.

How good are forecasts?

The key to share price performance is corporate earnings - or what annual profit is left to shareholders after all the costs of business have been deducted, such as salaries, investment in research or exploration, new plant and equipment, marketing initiatives and taxes.

Good investment analysts are able to forecast, with a reasonable degree of accuracy, the level of profits that can be expected over the next two to three years. It is these estimates that ultimately drive market prices.

It seems, from a study by John Authers of the Financial Times, that the analytical disciplines first defined by Benjamin Graham in the 1930s are today more honoured in the breach than the observance. Authers comments that, as late as July 2008, despite the forced sale of Bear Stearns and the imminent nationalisation of the two giants of the US mortgage business, analysts were forecasting a year-on-year rise of 37% in corporate earnings. Even in October, and after the bankruptcy of Lehman Brothers and the meltdown of bank share prices everywhere, the consensus was still for a 25% rise in earnings; only in December did it occur to analysts that the financial mayhem might affect profitability negatively. It was the analytical panic of March of this year, and the subsequent beating of those then dire forecasts by actual earnings, that showed that the financial world was not coming to an end.

Need for caution