Diversification basically means not putting all your eggs into one basket. But in investment, a ‘basket’ is defined in multiple different ways, so there are different dimensions across which you can diversify:
- Diversification across asset classes (e.g. equities vs bonds vs commodities)
- Diversification across countries or regions
- Diversification across economic sectors (e.g. technology vs healthcare vs energy)
- Diversification across individual stocks (or bonds) within a given asset class, country, or sector (e.g. Royal Dutch Shell vs BP)
- And the list goes on, almost endlessly
Someone wanting to be as diversified as possible would try to ensure they’re diversified across all of the above dimensions, and they may even take it a few steps further by, for example, measuring the size of their investments by amount of risk rather than amount of capital.
Diversification is a risk-reducing tool at the overall portfolio level. The idea is that when one thing in your portfolio goes down in value, something else should go up. For that to work, however, the correlations between the different assets in your portfolio must be less than one. A correlation of one between two assets means that they always move in the same direction over any given day, week, month, etc., depending on how you’re calculating it. Clearly, for diversification to work, you need the assets in your portfolio to be moving in different directions sometimes (negative correlation), or at least not be perfectly positively correlated (a correlation of one).
In investment, like in other walks of life, nothing is free. But diversification has been touted as the ‘only free lunch’ because of its ability to reduce risk in the portfolio without necessarily reducing returns.
Technically speaking, diversification reduces ‘idiosyncratic’ – or specific – risk. Theoretically, if you were as diversified as possible then no individual asset would have much of an impact on your overall portfolio results: any risk that is specific to any one asset would not be a risk to your overall portfolio. Diversification reduces specific risk.
What diversification doesn’t do is reduce market risk. That is, if the overall market – be it the stock market, the bond market, whichever market you’ve tried to be diversified within, goes up, then your portfolio goes up, and vice versa. Diversification within a particular market should not be expected to reduce market risk. Across different markets, e.g. across different asset classes, it is possible to reduce, say, equity market risk, by holding enough assets with a negative correlation to equities to offset the equity market risk.
Many investors hold the philosophy that specific risk is not rewarded over time, and that the only risk that gets rewarded is market risk. This broadly translates into a belief in the efficiency of markets. Even then, some markets, e.g. equities, are expected to consistently deliver positive rewards while some markets, e.g. commodities, are much less reliable. The implication of their philosophy, then, is that you should diversify as much as you can within each asset class. And if you hold multiple different asset classes, you should give some preference to those which are expected to deliver rewards over time (technically, they carry a reliably positive ‘risk premium’). Crucially, ‘over time’ is not a luxury everybody has, so understanding your time horizon is critical for getting this right.
The philosophy that specific risk is not rewarded is a sensible and prudent one for normal investors to adhere to. It may not be strictly always true, but it is true enough. Identifying individual stocks that will outperform the overall stock market is quite a difficult thing to do, and teams of well-resourced professional investors at asset management companies often struggle to do it consistently. As a rule, any specific risk taken on by normal investors should be extremely limited – the primary risk that you should be taking on in your portfolio is that of overall market risk. We discuss this subject a bit more in this article.
So, let us conclude by revisiting the main two dimensions of diversification: diversification within an asset class and diversification across asset classes. Diversifying within an asset class should be your neutral setting, and this is where you should always start. If you have extremely strong views about a particular stock, bond or other investment, then go ahead and invest in it, but keep the allocation small compared to your overall portfolio allocation to the asset class that it sits within. To use what is definitely not a technical term, you should only ever undiversify from your neutral setting to a very limited degree. The extent of your diversification across asset classes generally depends on your risk tolerance which depends largely on your time horizon. Equities are generally the undisputed champion of long-term return generation, and often the only reason to diversify away from them is to reduce your overall portfolio risk. So if you don’t need to reduce your overall portfolio risk – for example if you’re a young person investing for retirement – then your degree of diversification across asset classes should be limited, and your portfolio should be largely concentrated in equities.
Finally, don’t forget that diversification depends on correlation. And correlations are far from guaranteed. Something professional investors are grappling with right now – and probably for some time – is whether correlations have changed considerably enough to warrant revisiting their assumptions about how assets behave relative to one another. We will post on this subject and others related to it in the topical and advanced sections of the site.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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