The Importance of Diversification

How to find the balance between risk and return.

“Diversification is the only free lunch in investing” is a quote attributed to Harry Markowitz, the late economist and developer of modern portfolio theory. What he meant was holding a diversified portfolio was the only way to reliably increase your long-term return without adding additional risk.

Diversification is one of the first principles of investing. You probably understand the concept that you shouldn’t put all your eggs in one basket. Diversification is a way to spread your money across a variety of assets in your investment portfolio.

Why do you need to diversify? Because holding a single stock or asset exposes you to unsystematic risk, also known as idiosyncratic risk. When you own one stock, you are completely at the mercy of one company’s ability to generate profits and survive long-term. When you own multiple stocks, you diversify away this risk. The opposite of unsystematic risk is systematic risk, or market risk. Diversification can’t help with this risk, because it’s the risk we all take to get a return on investment, but diversifying can help deliver a long-term positive return.

Proper diversification helps expose you to a variety of stocks, countries and asset classes so you don’t become reliant on any single one.

Different Ways to Diversify

There are five primary levels of diversification:

1. Diversify Across Asset Classes

Owning a single asset class exposes you to the risk of that one asset class. Stocks expose you to short-term market risk. Bonds and cash expose you to the risk that your money won’t grow enough to reach your goals or will get killed by inflation. But all together they can help you achieve short-term and long-term goals when used appropriately.

2. Diversify Across Companies

Individual companies come with idiosyncratic risk. If a company misses its sales expectations, its CEO gets embroiled in a scandal or some new piece of legislation threatens its business model, these are all risks you can’t avoid if you’ve put all your money into the company’s stock. That’s why it’s important to own multiple stocks so when one does poorly, your overall portfolio doesn’t get hit as hard.

3. Diversify Across Sectors And Industries

Just as investing in a single company brings risk, so does owning several companies in the same industry. Imagine you only owned airline stocks in March of 2020. That would not have been a fun time for your portfolio. But if you had also owned technology stocks like Zoom, you would have been protected from a complete wipeout.

4. Diversify Across Global Markets

Investors tend to favor investing in their home countries over a more globally diversified portfolio. But this carries significant risk to long-term returns. No matter how good a country’s stock market performs, it’s unlikely to continue forever. Even the best stock markets can fall, and in the case of Japan, they can fall hard and experience many decades of poor performance. Every investor should add international markets to their portfolio.

5. Diversify Across Factors

Factors are characteristics that can help explain why some stocks outperform others. For example, academic research has shown that over long periods of time, small stocks outperform large stocks and stocks with lower valuations outperform stocks with higher valuations. Diversifying across factors is another layer of diversification that you can add to your portfolio to reduce overall volatility or even improve long-term returns.

However, some people can mistake certain strategies for diversification. For example, some people think they’re more diversified by spreading their investments across different investment platforms or owning multiple funds that play the exact same role in a portfolio, like owning two different S&P 500 funds. None of these strategies offer any meaningful diversification.

Diversification is Difficult But Necessary

The biggest obstacle to diversification is seeing how well a particular asset class or stock market is performing. This has been the case for nearly the entire post-GFC period with the U.S. stock market. A lot of investors take a look at the performance of U.S. stocks and the performance of international stocks and start asking, “What’s the point of owning international stocks?”

If history is any indication, this period of U.S. outperformance will come to an end, and when that happens, investors will probably be kicking themselves for not putting some of their money into international stocks.

Asset class diversification is particularly important for retirees. A 100% stock portfolio is great for younger investors who want as much of their money in growth assets as possible, but it can be a disaster for someone living off their portfolio. That’s why moving some money into bonds as you get older is standard financial wisdom.

Diversification rarely feels right in the moment, but long term, it protects against fluctuations in the market that can lead to irrational investor behavior and the risk that any one asset class or stock market severely underperforms another.

When Diversification is Overrated

There is such a thing as too much diversification.

Aside from the big three asset classes — stocks, bonds and cash — there are endless alternative investments. Some of these are serious long-term investments like real estate that nevertheless require a lot of work. Others are unproven (crypto), attract a certain weird person who always thinks the market is about to crash (gold) or are just too expensive and risky to effectively implement (wine, fine art).

You don’t need everything in your portfolio. If you just stick to stocks, bonds and cash, you’ve achieved all the diversification a normal person needs for their goals. Everything else is just a distraction.

How to Diversify Your Portfolio

The mechanics of diversifying your portfolio are easy. Just buy three index funds: a U.S. stock market fund, an international stock market fund and a U.S. bond fund. If you do this, you’ve achieved four of the five levels of diversification mentioned above. If you’re inclined, you can also throw in some small value funds like the ones from Avantis that I have in my portfolio. But this is a completely optional level of diversification that isn’t right for everyone.

Actually sticking to a diversified portfolio isn’t always easy, especially when one asset class or country is significantly outperforming another. It can be hard to resist the temptation to overweight whatever is doing well at the time.

In that sense, diversification isn’t actually a free lunch. It does come at a small cost. But you can reduce that cost by not paying attention to your portfolio too often. Focusing on the bigger picture and ignoring the noise will reward patient investors over the long term.