Among the most important tools available to investors is diversification. Diversification allows an investor to reduce investment risks while potentially improving investment returns.
But even though the benefits of diversification have been well-documented and widely explained by some 60 years of academic research, the concept is at first glance, counterintuitive.
After all, why in the world would we want to invest in a mix of investments where some do well and others perform poorly? Why not only invest in the “good” investments? It’s an excellent question, but there is also a simple answer.
The reason that investing only in the “good” investments won’t work comes down to one simple fact: we don’t know the future.
If we did know the future, concentrating your investments in one or two ideas would make sense. But the future performance of stocks and other investments relies heavily on future events that no one has any reliable way of predicting. And that is why we must diversify.
What is “Real” Diversification?
Many investors think they own a well-diversified portfolio because they own a large number of stocks or stock funds across numerous accounts. But upon closer analysis, it’s not uncommon to find that the bulk of the holdings are concentrated in a single asset class.
“Real” diversification means more than just ensuring you have many holdings. It means owning multiple asset classes that behave differently in various market conditions and respond differently to various economic events.
For example, a portfolio of 30 tech stocks is not diversified, nor is a portfolio made up of only dividend-paying bank stocks or high yielding corporate bonds. Even an investment in an S&P 500 index fund which gives an investor exposure to a basket of 500 stocks is not necessarily diversified because it ignores about 70% of the global stock market and bonds of all types.
And even some portfolios that include both stocks and bonds may not be sufficiently diversified. For example, U.S. stocks and high yield corporate bonds are both dependent on the fortunes of US companies. As a result, they tend to be highly correlated at exactly the worst time – when stocks are down sharply.
With some careful investment planning and an understanding of how various asset classes work together, a properly diversified portfolio provides investors with an effective tool for reducing risk and volatility, without necessarily giving up a return. Diversification is the elusive “free lunch” in investing.
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