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Beginner’s guide to diversification in investing
It’s not possible to become a successful investor without understanding and implementing the timeless principle of diversification.
QUOTE
“If you invest and don't diversify, you're literally throwing out money. People don't realise that diversification is beneficial even if it reduces your return. Why? Because it reduces your risk even more.”
This article will explain diversification in depth, with examples and definitions, so you can intelligently incorporate it into your portfolio. Preserving existing wealth is as important as creating more of it, a fact often missed by market newcomers.
Big ideas
- Diversification in investing is a principle used by all successful investors aimed at reducing risk and increasing longevity in your portfolio.
- There are many ways and forms of diversification. Proper diversification depends on the industry, risk tolerance, and correlation between securities.
- Protecting your portfolio is as important as growing your portfolio.
What is diversification in investing?
A diversified portfolio is where total investment allocation is split among different industries and businesses to reduce risk.
The reason is that selecting a poorly performing stock in a good industry is possible. It’s also possible to invest in many trading instruments in a given industry only for that industry to witness a downturn.
The reason is that selecting a poorly performing stock in a good industry is possible. It’s also possible to invest in many trading instruments in a given industry only for that industry to witness a downturn.
In other words, the more your portfolio is “spread out” among different securities and industries, the more protected it is against any adverse events that may happen. The reality is that nobody can predict the way that a market will go or what will happen in the future. Plus, it’s easy to pick “good” stocks when the wider market is overvalued.
Diversification in investing is actually quite a simple concept to understand, it's just that it is harder to stick to and implement over a longer time horizon. This is especially true amidst bull markets, where everybody is confident in the market and even dismissive of more defensive strategies.
Diversification in investing is actually quite a simple concept to understand, it's just that it is harder to stick to and implement over a longer time horizon. This is especially true amidst bull markets, where everybody is confident in the market and even dismissive of more defensive strategies.
QUOTE
“The only investors that don’t need to diversify are those that are right 100% of the time”
Diversification in investments is an essential principle of wealth preservation. If all of your stocks are in the tech market, you might see impressive gains if the market goes up. But you could lose everything if the market goes in the other direction. Spreading your allocation among different industries prevents this.
It can get much more complicated and involved than diversifying amongst stocks and industries. You can diversify across time to average out returns and price entry (a technique known as dollar cost averaging). You can invest in securities other than stocks, though some contend that asset allocation and diversification are separate categories.
You could also invest in securities that are inversely correlated. This means that when one goes up, the other moves in the opposite direction. Owning a smaller amount of securities that are hedged against each other can also reduce risk.
It can get much more complicated and involved than diversifying amongst stocks and industries. You can diversify across time to average out returns and price entry (a technique known as dollar cost averaging). You can invest in securities other than stocks, though some contend that asset allocation and diversification are separate categories.
You could also invest in securities that are inversely correlated. This means that when one goes up, the other moves in the opposite direction. Owning a smaller amount of securities that are hedged against each other can also reduce risk.
How to create a diversified portfolio. The basics
There are many different opinions and theories as to what constitutes diversification in a portfolio. A rule of thumb is that a portfolio should have at least 20 to 25 stocks in order to be considered balanced. And at most, 5% should be allocated to a given stock.
This ensures portfolio protection against firm-specific risk (the risk that the companies are valued incorrectly or fail to perform for various reasons).
A truly diversified portfolio should also be diversified across markets to protect against market-specific risk. A portfolio of 25 stocks might be spread out amongst 5 different markets. One market might drop, but it is unlikely that all 5 will.
Finally, balanced diversification in a portfolio will have different asset allocations. Some assets are more popular than others, including stocks, international stocks, bonds, and cash (due to liquidity, risk, and return). Alternative asset classes include real estate (REITs), commodities and emerging markets.
Newbie investors may have as little as two or three stocks in their portfolios, selected based on market hype and online news. This is not a diversified portfolio!
This ensures portfolio protection against firm-specific risk (the risk that the companies are valued incorrectly or fail to perform for various reasons).
A truly diversified portfolio should also be diversified across markets to protect against market-specific risk. A portfolio of 25 stocks might be spread out amongst 5 different markets. One market might drop, but it is unlikely that all 5 will.
Finally, balanced diversification in a portfolio will have different asset allocations. Some assets are more popular than others, including stocks, international stocks, bonds, and cash (due to liquidity, risk, and return). Alternative asset classes include real estate (REITs), commodities and emerging markets.
Newbie investors may have as little as two or three stocks in their portfolios, selected based on market hype and online news. This is not a diversified portfolio!
A diversified portfolio example with stocks & bonds
The image below shows the diversified portfolio of David Swensen, who made a 16.3% annual return for over 20 years for the Yale University Endowment fund. These are exceedingly rare returns, with 8% being impressive for most fund managers.
David Swedsen portfolio
It’s also important to keep in mind that Swensen actively managed this portfolio while also ensuring it was diversified across assets. The asset allocation as per this model is as follows:
- Domestic stocks - 30%
- Real estate funds - 20%
- Government bonds - 15%
- First world international stocks - 15%
- Treasury inflation-protected securities (TIPS) - 15%
- Emerging market stocks - 5%
This portfolio is diversified in its asset allocation. It is a relatively even spread, with slightly more emphasis placed on domestic stocks than emerging market stocks. This means that no upset in any category will unduly affect the portfolio.
Remember that any sector or market can go bust at any time. Diversifying across asset classes is a good way to offset this risk, regardless of the total dollar amount. The amount is not relevant to diversification in a portfolio.
Also, remember that asset allocations are not absolute. There are successful investors with diverse asset allocations. You can have a 100% diversified stock portfolio or diversification within the real estate market.
Remember that any sector or market can go bust at any time. Diversifying across asset classes is a good way to offset this risk, regardless of the total dollar amount. The amount is not relevant to diversification in a portfolio.
Also, remember that asset allocations are not absolute. There are successful investors with diverse asset allocations. You can have a 100% diversified stock portfolio or diversification within the real estate market.
What are the 4 primary components of a diversified portfolio?
A diversified portfolio will typically contain 4 primary components - domestic stocks, international stocks, bonds, and cash. Sometimes mutual funds will feature instead of international stocks.
- Domestic stocks - These will nearly always feature heavily in any given portfolio. Some stocks can generate dividends, depending on the company. Stocks have the potential to generate higher returns than other assets, but the higher risk needs to be offset.
- International stocks - a stock in any market other than which you live/operate will be deemed international. If you operate from the UK, a US stock will be considered international, and vice versa. This protects you against adverse movements in your domestic area. Owning international stocks opens you up to movements in foreign exchange markets. If your local currency rises relative to the currency of the stock you bought, your P&L will be negatively affected. Vice versa for a falling domestic currency.
NOTE: Emerging markets are their own distinct class with their own series of risks and are an alternative asset class. - Bonds - bonds generate fewer returns than stocks but are safer. They offer protection from stock market risk and a set rate of return for lending out your money.
- Cash - cash refers to all currency you have in all bank accounts as well as certificates of deposit and treasury bills. Cash is the least volatile asset, but it is not offering a return. Many banks charge you for a current account, meaning you pay for leaving cash in a bank (a form of negative interest) and you also have to compete against inflation, which devalues money over time.
Of course, you can also choose some alternative asset classes and there will be a difference in terms of how much of your available funds are allocated towards.
A diversified portfolio might be 40% domestic stocks, 20% international stocks, 20% bonds, and 20% cash.
A diversified portfolio might be 40% domestic stocks, 20% international stocks, 20% bonds, and 20% cash.
The role of risk tolerance in investment diversification
Diversification cannot be separated from risk tolerance. Younger people are usually advised to put more of their earnings into stocks than safer assets. This is because they have a lifetime of earning potential, which will compound with time.
In contrast, advice for older generations is usually to allocate more of their portfolios towards safer assets like bonds and cash. The reason is that they are mostly past the income-earning age and want to preserve existing wealth. The returns they make will have less time to compound with time unless they consider passing it on.
An investor in their twenties might place 80% in stocks and 20% in bonds and mutual funds. Conversely, an investor in their seventies might put 30% in stocks and 70% in bonds and mutual funds.
In contrast, advice for older generations is usually to allocate more of their portfolios towards safer assets like bonds and cash. The reason is that they are mostly past the income-earning age and want to preserve existing wealth. The returns they make will have less time to compound with time unless they consider passing it on.
An investor in their twenties might place 80% in stocks and 20% in bonds and mutual funds. Conversely, an investor in their seventies might put 30% in stocks and 70% in bonds and mutual funds.
Assessing portfolio risk with the Sharpe ratio
Diversification is a function of risk tolerance. And the risk of a portfolio is typically measured using the Sharpe ratio. While this ratio does not tell everything, it is certainly a useful indicator for assessing portfolio risk.
It is useful in determining the volatility of the portfolio over time, as compared to a benchmark. It can also help to determine how adding an asset to a portfolio will affect the risk-adjusted returns of that portfolio. A Sharpe ratio above 1 is generally considered attractive, but it depends on the industry.
It is useful in determining the volatility of the portfolio over time, as compared to a benchmark. It can also help to determine how adding an asset to a portfolio will affect the risk-adjusted returns of that portfolio. A Sharpe ratio above 1 is generally considered attractive, but it depends on the industry.
FORMULA
Sharpe Ratio = (Rate Of Return - Risk Free Rate)/Standard Deviation Of Portfolio Excess Return
The higher the sharpe ratio for a given portfolio, the better its performance when risk is accounted for. This is of critical importance to understand, as financial markets can become fraught with hype and hysteria.
NFTs, cryptocurrency, and hot tech stocks can have an exceptional year with great returns. But what kind of volatility is associated with that kind of investment, and is it sustainable? The Sharpe ratio is highly useful here as it puts things in perspective.
NFTs, cryptocurrency, and hot tech stocks can have an exceptional year with great returns. But what kind of volatility is associated with that kind of investment, and is it sustainable? The Sharpe ratio is highly useful here as it puts things in perspective.
Remember, you want returns without taking on undue risk. You can play roulette and hit black five times in a row. That does not make black a good investment for the next turn. But the rate of return will show 100% each year for the roulette roll.
Aside from the Sharpe ratio (which does have certain limitations), other options for assessing risks and rewards of portfolios include the Treynor ratio, which includes the portfolio beta, and the Sortino ratio, which includes the downside deviation. Both are used to calculate portfolio risk but consider different variables.
Aside from the Sharpe ratio (which does have certain limitations), other options for assessing risks and rewards of portfolios include the Treynor ratio, which includes the portfolio beta, and the Sortino ratio, which includes the downside deviation. Both are used to calculate portfolio risk but consider different variables.
Using diversification across time
Another form of diversification refers to time, also known as dollar cost averaging (DCA). Again, this is mainly a hedge against the fact that you can’t possibly gauge all the variables in terms of price movement. This helps to mitigate timing risk.
Diversifying your portfolio
If you invest in a specific fund or stock at different time intervals, such as three months for three years, you will have purchases at various price points. This saves you time because no individual research into the market is required.
It also ensures that you get a decent rate of return. It’s possible that you do a lot of research and still purchase at the top, giving you the worst possible scenario.
Most importantly, it reduces emotional investing. If you have $10,000 and are waiting for the right stock, you can easily lump it all into a stock that takes your fancy. All it takes is one mistake, and the portfolio could be wiped out due to carelessness.
But your money might have been well spent if you auto-invested this into a diversified portfolio at $2,500 every 3 months. And you would have been saved from the worst enemy of any investor - emotional decision-making combined.
DCA is ideally suited for younger investors because the earlier you invest, the better your money will perform when compounding returns are considered.
It also ensures that you get a decent rate of return. It’s possible that you do a lot of research and still purchase at the top, giving you the worst possible scenario.
Most importantly, it reduces emotional investing. If you have $10,000 and are waiting for the right stock, you can easily lump it all into a stock that takes your fancy. All it takes is one mistake, and the portfolio could be wiped out due to carelessness.
But your money might have been well spent if you auto-invested this into a diversified portfolio at $2,500 every 3 months. And you would have been saved from the worst enemy of any investor - emotional decision-making combined.
DCA is ideally suited for younger investors because the earlier you invest, the better your money will perform when compounding returns are considered.
Pros of diversification in investing
Diversification in investing is important because it is one of the safest and most established ways to preserve existing wealth. It will ensure you remain protected from downturns in specific industries. The primary advantages of diversification in investing are:
✔️ Reduces market volatility
A well-diversified portfolio will be protected against adverse market movements.
✔️ Preserves wealth
Because the portfolio is not allocated to a specific stock or industry, it helps to sustain existing gains. This is safer than having all profits in cash alone.
✔️ Reduces management
It's easier to select a diversified portfolio than to choose winning stocks, which is far more difficult than it's made out to be. As it's often passive, this further reduces management fees.
✔️ More successful
Though this is a contested area, a diversified portfolio that is not actively managed can beat an actively managed selected portfolio over time. Obviously, this will depend on the type of passive, diversified portfolio and the type of actively managed portfolio.
✔️ Peace of mind
Investors do not have to worry about a particular industry going up or down because they have a piece of many pies. Diversification in investing means less stress and often more success.
Cons of diversification in investing
Diversification does have specific disadvantages, which need to be understood. The main point is that diversification has the potential to reduce overall returns.
This is particularly true for more experienced investors because these investors are doing the research into specific stocks with the highest possible value and lowest risk.
This is particularly true for more experienced investors because these investors are doing the research into specific stocks with the highest possible value and lowest risk.
Consider a show such as Dragons Den. The “Shark” investors in this show do not want to be in every single opportunity. They look for the very best deals to maximise returns. But this principle is only true for established investors, and even then, they are often highly diversified.
❌ Reduced rate of return
Diversification means that the investor is not actively looking for elite stocks with high returns but a basket of stocks that perform “ok” and are designed protectively.
❌ Longer to build wealth
At some stage, all investors need to look towards making more than average. A diversified portfolio will take far longer to build wealth than a concentrated one.
❌ Can be taken too far
A fund manager that takes 200 “diversified” positions has no idea what is going on with any of them. The most successful fund managers and investors are capitalistic, patient, and aggressive. Poor companies still need to be eliminated from a portfolio based on existing data.
Critiques of diversification in investing
Warren Buffet, and some other investors, are known for being quite critical of diversification in investing, implying that it is only useful for ignorant people who don’t know what they are doing.
QUOTE
“Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing”
But the reality is that when it comes to the market, nobody truly knows what they are doing. It’s not possible to understand which way the markets will go. We are all ignorant when it comes to the market! There is so much to learn, and even very advanced investors can get hit without being diversified.
It’s true that the more knowledge and skill you have, the less important it is to diversify. But unless you have access to industry insights before the market, decades of experience in a role, or other specialized skills or information, diversification is the primary wealth preservation mechanism.
Picking the right stocks is a lot more difficult than it appears. You are competing against a market of experts, PH.Ds, high-frequency traders, and industry insiders. You are also competing against Lady Fortune, so even if you do everything right, the prices may not go in your direction - yet another reason for portfolio diversification.
It’s true that the more knowledge and skill you have, the less important it is to diversify. But unless you have access to industry insights before the market, decades of experience in a role, or other specialized skills or information, diversification is the primary wealth preservation mechanism.
Picking the right stocks is a lot more difficult than it appears. You are competing against a market of experts, PH.Ds, high-frequency traders, and industry insiders. You are also competing against Lady Fortune, so even if you do everything right, the prices may not go in your direction - yet another reason for portfolio diversification.
How to diversify your portfolio in 2023?
Source: Trading212. Past performance doesn’t guarantee future results.Portfolio diversification is not as difficult as it once was. Pies & AutoInvest make it easier to diversify a portfolio, while also allowing you to manually select stocks to include. They also show the price and fees for each, which was not always the case.
Pies are a combination of stocks and ETFs. Each pie can hold a maximum of fifty securities, and you can have many pies. The auto investment feature allows for a continual investment of a set amount over time.
This is essentially dollar cost averaging, where you set a specific amount you would like to invest into a pie or individual security. This removes a lot of stress and headaches surrounding the selection of securities.
Pies are a combination of stocks and ETFs. Each pie can hold a maximum of fifty securities, and you can have many pies. The auto investment feature allows for a continual investment of a set amount over time.
This is essentially dollar cost averaging, where you set a specific amount you would like to invest into a pie or individual security. This removes a lot of stress and headaches surrounding the selection of securities.
Recap
Diversification is one of the most important principles for new investors and the best way to preserve existing wealth, which is as important as creating more. Looking for sky-high returns in one or two investments is a surefire way to blow your savings.
At the same time, the problem of over-diversification is well established. You can make intelligent decisions based on market data and insights, and you can make the most out of your existing capital.
Be patient and diversify, but if an opportunity arises, don’t be afraid to take advantage, as long as it's not with your entire bankroll. Overdiversificaiton is almost as big an issue as not being diversified, and balance is required.
At the same time, the problem of over-diversification is well established. You can make intelligent decisions based on market data and insights, and you can make the most out of your existing capital.
Be patient and diversify, but if an opportunity arises, don’t be afraid to take advantage, as long as it's not with your entire bankroll. Overdiversificaiton is almost as big an issue as not being diversified, and balance is required.
FAQ
Q: What are the three factors to consider in diversification?
The three main factors to consider for diversification in investing are time, asset allocation, and equity spread. Time refers to investing a certain amount at specific intervals to avoid emotional investing and reduce the chances of picking the wrong point of entry.
Asset allocation means that you invest in a mix of high-risk and low-risk assets in a proportion that complements your risk tolerance and investor preferences. Equity spread means that you have a suitable number of stocks in your portfolio. Three or four is not enough unless they are diversified ETFs with numerous stocks.
Asset allocation means that you invest in a mix of high-risk and low-risk assets in a proportion that complements your risk tolerance and investor preferences. Equity spread means that you have a suitable number of stocks in your portfolio. Three or four is not enough unless they are diversified ETFs with numerous stocks.
Q: Can you lose money in a diversified portfolio?
It’s possible to lose money in any portfolio. A widespread economic turndown will affect all portfolios, such as the 2008 banking crises or the 1987 stock market crash.
But the difference is that a diversified portfolio in 2008 or 1987 will survive and bounce back over the years. A portfolio involved in real estate in 2008 or focused on stocks in 1987 will get crushed and will be very difficult to recover.
So even if you lose money, it will help you to stay “alive”, just like any form of insurance.
But the difference is that a diversified portfolio in 2008 or 1987 will survive and bounce back over the years. A portfolio involved in real estate in 2008 or focused on stocks in 1987 will get crushed and will be very difficult to recover.
So even if you lose money, it will help you to stay “alive”, just like any form of insurance.
Q: What are the 4 methods of diversification?
This typically refers to corporate diversification and not investment diversification. The four methods of corporate diversification are horizontal, vertical, concentric, and conglomerate.
Horizontal diversification relates to the addition of a new product to a company's supply line with relevance to its existing customers. Vertical diversification is when a company expands its production in terms of the supply chain (such as Netflix launching its own movies).
Concentric diversification is the addition of a new but related product to the current offerings, so no new infrastructure is needed. Conglomerate diversification is when a company morphs into something completely new and unrelated to previous offerings.
Horizontal diversification relates to the addition of a new product to a company's supply line with relevance to its existing customers. Vertical diversification is when a company expands its production in terms of the supply chain (such as Netflix launching its own movies).
Concentric diversification is the addition of a new but related product to the current offerings, so no new infrastructure is needed. Conglomerate diversification is when a company morphs into something completely new and unrelated to previous offerings.
Q: Why do most investors hold diversified portfolios?
Because it is one of the most sensible options to protect wealth. It’s challenging to beat the market. And sometimes, you can beat the market randomly or accidentally but still assume it was because of your chosen strategies. And no industry is impervious to “black swans”, no matter what the data looks like now. Technology, in particular, can be a complete game changer.
A diversified portfolio can actually reduce your total exposure while also reducing the time you need to research the market. You don’t need to know it all when you are diversified because you get a piece of many pies. Robo-advisors are a form of passive ETF investing without users having to do any work besides saving and investing.
And there is much evidence that passively diversified investments beat actively managed funds, especially when management fees are accounted for.
A diversified portfolio can actually reduce your total exposure while also reducing the time you need to research the market. You don’t need to know it all when you are diversified because you get a piece of many pies. Robo-advisors are a form of passive ETF investing without users having to do any work besides saving and investing.
And there is much evidence that passively diversified investments beat actively managed funds, especially when management fees are accounted for.
Q: Does diversity increase profit?
Diversification in a portfolio does not increase profit. Many investors are critical of diversification, saying that it decreases profits. Yet this is somewhat misleading. House, car, flight, and life insurance do not increase your earnings.
Similarly, a stock market crash could wipe you out, especially if you have to sell out in order to pay for other things. Following Murphy’s law, crises often happen at the same time.
Of course, diversification can also result in profit increases as compared to a specific scenario. An investor might decide that a specific industry is going to expand and invest in lots of stocks in this sector. If the industry crashed instead, investment diversification would have resulted in better results than the concentrated portfolio.
Similarly, a stock market crash could wipe you out, especially if you have to sell out in order to pay for other things. Following Murphy’s law, crises often happen at the same time.
Of course, diversification can also result in profit increases as compared to a specific scenario. An investor might decide that a specific industry is going to expand and invest in lots of stocks in this sector. If the industry crashed instead, investment diversification would have resulted in better results than the concentrated portfolio.
Q: How many stocks should I own to diversify?
There is some debate regarding this, NYU’s Stern School of Business’s Haran Segram says that you need a minimum of 20 stocks to be considered diversified. Many market participants may have as few as three or four stocks, which is insufficient to protect against market downturns. Generally, no more than 5% should be invested in a single stock. Otherwise, your portfolio is at risk if something happens to that stock.
However, you can simply invest in an ETF that is designed for diversification. You can also invest in several ETFs. This is easier than selecting individual stocks, which would take more time and expertise.
However, you can simply invest in an ETF that is designed for diversification. You can also invest in several ETFs. This is easier than selecting individual stocks, which would take more time and expertise.
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