Back

Diversifying a portfolio

Lesson in Course: Portfolio management (beginner, 5min)

Investing requires taking some risk. Here is a way to reduce the amount of risk.

Eureka!

What it's about: Diversification allows us to spread out our risk.

Why it's important: Without diversification, we can unintentionally lose a lot of our money.

Key takeaway: We can get great diversification benefits by adding two different asset classes.

Diversification is the process of reducing the risk of a portfolio by investing in a variety of assets. We can remember this using the adage, “don’t put all of your eggs in one basket.” By investing in various assets, we reduce the exposure to any one particular asset or risk. This way, if anything bad happens to one asset, we don’t lose all of our money, or if something happened to one basket, we don’t lose all of our eggs.

We can diversify by investing in different asset classes such as stocks, bonds, or crypto. Or we can diversify within each asset class, such as buying stock in Tesla and Walmart.

 

How diversification works

Diversification has a greater effect when there is less correlation between the assets. By investing in various assets, we can expect to see the value of some go up while others go down. This means that losses of some assets are offset by gains of others which reduces how much the total portfolio fluctuates. These fluctuations are what we use to measure risk, so we reduce the risk of our portfolio by reducing these fluctuations.

Reducing losses allows wealth to compound

Let's take a practical look at diversification and risk. A classic debate among soda drinkers has always been between Pepsi or Coca-cola for taste. Let's assume that one of our friends is a Pepsi fanatic and manages to convince us that Pepsi was going to come out with some blockbuster flavors over the next years. He decides to invest in Pepsi exclusively. We decide to follow suit but will create two portfolios to diversify our risk.

Three portfolios 

The graph below shows the growth of three portfolios over two years, from April 17, 2006, to September 30, 2008.

  • Portfolio 1 is a portfolio made up of one stock, Pepsi ($PEP).
  • Portfolio 2 is a portfolio made up of two stocks, Pepsi ($PEP) and Coca-cola ($KO).
  • Portfolio 3 is made up of Pepsi ($PEP), an ETF of 7-10 year Treasury bonds ($IEF), and an ETF of the price of gold ($GLD).

Investing in Pepsi stock and Coca-cola stock will reduce some risks. However, it is much less than if we created a portfolio invested in Pepsi stock, Treasury bonds, and gold because there is a greater correlation between Pepsi and Coca-cola than Pepsi, Treasury bonds, and gold.

At this point, it seems like all three portfolios are doing well after two years.

Not only are Pepsi stock and Coca-cola stock both the same type of asset, but both companies have similar product offerings and risks. Combining the two doesn't reduce our beta or overall risk by much.

Portfolio 1 and 2 stats

Portfolio 1 and 2 look very similar, and that’s because $PEP and $KO have a fairly strong correlation (0.68). 

 

In contrast, bonds and gold are different asset classes that have different associated risks. The greater these differences are, the more diversification can be achieved. Let's take a look at portfolio 3.

Portfolio 3 stats

The beta for portfolio 3 (0.15) is much lower than $PEP.

In our example, we compared the performance of both portfolios between 2006 and 2008, 2 years of strong economic growth. During economic expansion, high-risk (beta) stocks perform well and it almost doesn't matter what we pick. However, had we been in an economic recession, things would be quite different. Let's take a look at what happened over the following months.

The financial crisis of 2008

If we extend our timeline to January 20, 2009, we can see the effects of diversification at play.

After news of Lehman Brothers' collapse, the stock market crashed. We can see that portfolio 1 and portfolio 2 sustained heavy losses while portfolio 3 came out on top.

We've learned in previous lessons that long-term wealth building requires limiting as many big losses to our portfolio as we can. One big setback can really slow our progress and erase years of progress. This is why hedge funds are entirely built to manage and reduce risk. Just like those firms, we should not skimp on diversification! 

Actionable ideas

Diversification is an easy way to reduce the risk of a portfolio. By adding more varying types of investments to our portfolio, we can continue to reduce portfolio beta or risk. While it may seem counter-productive to give up possible returns, reducing risk is necessary during economic contractions for long-term investing success.

Supplementary materials

Use this free tool to play around with different portfolios to see how you can minimize the risk while trying to maximize the return:

Backtest Portfolio Asset Allocation

Analyze and view backtested portfolio returns, risk characteristics, standard deviation, annual returns, and rolling returns

https://www.portfoliovisualizer.com/backtest-portfolio