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