Diversification is perhaps one of the oldest and most important concepts in the entire world of investing. The basic idea involves making investments in a wide variety of different assets in an effort to minimize risk -- a concept that forms the central tenet behind famed finance professor Dr. Harry M. Markowitz's "efficient frontier" theory, which he developed in 1952. It sounds technical, but diversification is little more than a sophisticated version of the adage "Don't put all of your eggs in one basket."
Why Should You Diversify?
Because some investments rise in value while others decline, the basic reason diversification is important is that it tends to dramatically lower the overall risk in an investor's portfolio. It can help an investor take on risk-bearing assets without running the risk of getting completely wiped out when one goes south.
For example, let's assume you have two stocks in your portfolio. If one stock moves up when the other stock moves up, these stocks are highly correlated. When one stock goes down, the other stock goes down, and the investor could really suffer. However, if the investor chooses two stocks that are not correlated, then when one stock goes up, the other might go down. Of course, the investor doesn't reap the windfall that she would had she bought the two correlated assets that went up. But she also doesn't get wiped out when the two correlated assets tank. Instead, when one of her stocks goes down, the other one goes up. She doesn't lose a penny. She diversified.
How many securities does it take to diversify a portfolio? There isn't one answer. A portfolio that consists of a group of 20 or 30 stocks spread across many different sectors should provide adequate diversification for an equity portfolio, but that's just a rule of thumb. By comparison, a portfolio of just 5 to 10 stocks is likely to be much more volatile. Meanwhile, to diversify a fixed income portfolio, an investor may wish to purchase a basket of securities with varying levels of risk and different maturity dates.
What Can Really Happen If You (Or Your Portfolio Manager) Don't Diversify?
An example of the problems inherent in holding a concentrated portfolio occurred within the technology sector in early 2000. In the late 1990s, investing exclusively in technology stocks appeared to be a prudent strategy. After all, at that point in time the tech-laden Nasdaq Composite was posting annual gains of over +20%.
However, when the technology sector eventually crashed in 2000, many investors who held large concentrations of these stocks experienced dramatic portfolio declines of 80% or more. It took years and years for many of these investors to recover from those brutal losses. By comparison, however, most investors who held a diversified basket of stocks (representing technology and a host of other sectors) managed to hold up quite well during the tech slump. Diversification also makes funds much less volatile than individual securities.
How Do I Diversify My Portfolio?
There are a variety of different ways to diversify a portfolio, but the basic idea is to invest in a diverse set of asset classes (such as stocks, bonds, cash, and real -- even collectibles and precious metals count) and then invest in a diverse set of assets within those classes.
For example, an investor with a long investment horizon may decide to invest 80% of his/her portfolio assets in stocks, 10% in fixed-income securities, and 10% in cash. By contrast, an investor with a shorter timeline might decide to be a bit more cautious. He or she might choose to allocate 60% to stocks, 30% to bonds and 10% to cash.
Another diversification method involves allocating a certain percentage of one's portfolio to various investment categories within each asset class. For example, an aggressive investor may choose to allocate 80% of his/her equity holdings to growth stocks and 20% to stocks that pay rich dividends.
There is no such thing as a perfectly diversified portfolio, because different investors need different types of diversification. For example, younger investors are better off investing a larger portion of their portfolio in riskier assets than older investors are. Thus, their decisions about how to diversify will differ. Tax situations and family needs such as college funds or senior care also influence how an investor should diversify his or her portfolio.
Some Important Diversification Tools
Mutual funds and ETFs are two of the most popular and easiest ways to instantly diversify, because each fund holds a broad array of investments. This allows investors to gain broad exposure to a large group of companies within a sector or asset class easily.
Index funds, for example, are a popular way to diversify a portfolio across the entire stock market, while foreign index funds in particular make diversifying abroad less difficult and expensive. Bond funds come in an almost-unlimited number of flavors as well.
Sometimes funds concentrate only on very specific sectors or markets (such as steel or China), and although these kinds of funds may be a great way to diversify within a sector, they do not provide broader diversification across the entre market. In other words, owning a mutual fund does not mean your portfolio is diversified. That's why it's important to read the prospectus and understand where the fund manager's focus is.
On that note, it is worth repeating that asset class and sector are two different things. Investing in one mutual fund does not diversify you across asset classes if it only invests in stocks. Likewise, if you are allocating a portion of your portfolio to the bond asset class, don't sink it all into the bonds of one issuer. Many homeowners have also learned that real often consumes a large portion of their total portfolio, and keeping this in mind when diversifying can avoid creating an inadvertently lopsided portfolio as well.
Studies show that asset allocation tends to have more influence on returns than individual stock selection within those asset classes, so the majority of your time should center on what percentage of your money should be in stocks, bonds, real , etc. rather than on the specific securities within those classes.
And of course, the Bernie Madoff scandal has also highlighted the lesson that investors should also diversify their funds among managers. Those who give all of their money to one fund company could still be shouldering a surprising amount of hidden risk, even if the money is spread among a variety of investments within that fund company.
In the end, diversification is one of the cornerstones of not only financial theory but everyday investing. Though it is possible to overdiversify (where the investor ends up with what is basically a homemade, time-consuming index fund), wise investors will incorporate the concept of diversification into every decision they make.