Diversification is one of the most elementary and popular investing strategies available to all levels of investors, from the most sophisticated pension funds to college students opening their first investment account.
The foundation of diversification is simple: don’t put all your eggs in one basket. But, like any investment strategy, diversification comes with its own list of positives and negatives. For example, diversification is a good way to preserve wealth, but concentration is often a better way to build a fortune. Understanding these characteristics can help investors make informed decisions about their investment approach.
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Diversification is a way to reduce risk in your portfolio by spreading your investments across different assets. Rather than betting your entire savings on the stock of a single, specific company, you prefer to own shares in several companies across various industries.
Benefits to diversification
Columbia Business School professor Benjamin Graham said in his seminal text, Security Analysis, that “diversification is counted upon to offset the recognized risk existing in the individual securities.”
One of the primary benefits of diversification is risk reduction. By spreading investments across different assets, sectors or geographic regions, investors can mitigate the impact of adverse events on their portfolio. Diversification reduces an investor’s overall level of volatility and potential risk. If investments in one area perform poorly, other investments in the portfolio can offset losses.
With diversified holdings, your portfolio is less likely to lose a lot of value just because any single investment does not perform well. This is particularly true when investors hold assets that are negatively correlated. If the value of one stock falls, you can still rely on your other investments to lessen the burden.
Diversification can also help smooth out the peaks and valleys you may experience in your investment returns over time. Some investments may experience volatility or downturns, but others may perform well, leading to a more consistent overall return. This can be particularly beneficial for investors with a low tolerance for volatility.
Investing in various assets increases the probability you will always have at least some winners to offset losers. Although diversification does not eliminate volatility — because investors are still exposed to stock market risk — it offers a smoother investment experience as the high peaks and low valleys of your investment portfolio tend to cancel each other out.
Another benefit of diversification is that it allows investors to access a wide range of investment opportunities. By investing across various sectors, industries and asset classes, investors can take advantage of emerging trends and opportunities, while minimizing exposure to any single investment.
Drawbacks to diversification
The challenges of diversification are less publicized than their attributes, and therefore tend to be less well-known. The reality is that despite its many benefits, diversification can also have some unintended adverse effects on an investment portfolio.
First and foremost, while diversification can reduce volatility and offer a more consistent investment return over the long term, having more investments in your portfolio tends to limit potential gains and produce average results.
By spreading investments across different assets, investors may miss out on the significant gains that could result from concentrated bets on high-performing assets. In other words, diversification can act as a drag on returns, especially during bull markets. The more extensively diversified an investment portfolio, the more likely it is to mirror the performance of the overall market.
What’s the point of owning your 40th best idea? “The whole secret of investment is to find places where it is safe and wise not to diversify,” Charlie Munger of Berkshire Hathaway Inc. once said.
Despite efforts to diversify investments, some assets may still be highly correlated. This is particularly evident during times of market duress. For example, during the 2008 global financial crisis, many seemingly unrelated assets simultaneously declined as investors flocked to safety. This came as a shock for most investors. In such cases, diversification may offer only limited protection, as the correlations among assets increase during Black Swan events.
Maintaining a diversified investment portfolio also requires ongoing monitoring and rebalancing to ensure the desired asset allocation is maintained. This can be both challenging and time-consuming, especially for individual investors without the resources or expertise to actively manage their portfolios.
British fund manager Terry Smith has said that “the more stocks you own, the less you know about each of them, and I have never found a theory of investment that suggests that the less you know about something, the more likely you are to generate superior returns.” He makes a persuasive argument.
Overall, diversification is a cornerstone of prudent investing, offering numerous benefits including risk management, steady returns and exposure to different opportunities. However, despite its many benefits, it’s essential for investors to be aware of the potential drawbacks of diversification, such as lower returns, difficulties with monitoring your portfolio and remembering that diversification is not infallible.
The best path for an educated investor may be to aim for a modest amount of diversification while primarily focusing on selecting high-quality investments. Moreover, as your financial situation becomes more complicated, you may want to seek some input from a professional when it comes to managing one’s investment portfolio.
Nevertheless, by carefully balancing the pros and cons of diversification and aligning your investment strategy with your financial goals and risk tolerance, investors can construct portfolios that offer a favourable risk-return profile over the long term.
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