Why Diversify?

Diversification is the strategy of spreading your money among different types of investments. But why? Why not pick what you think will do best and let it ride?

There are numerous examples of diversified portfolios doing poorly. In 2013, for example, if you’d invested only in US-based stocks, you would have done better than a diversified investor. Same goes for 2015. Those bonds and foreign stocks did nothing but hold you down. What’s more, you might have had your eye on a few individual stocks or sectors that beat the S&P 500 index.

Even though it’s possible to do better by keeping your investment money concentrated in a few places, it’s probably not the best idea. Let’s go over the reasons for diversification, starting with the obvious and moving to the less obvious.

A diversified portfolio is like a balanced diet. Unless you're gluten-free...

A diversified portfolio is like a balanced diet. Unless you’re lactose-intolerant

If you’re wondering how to diversify, the easiest way is probably to use mutual funds. You’ll get access to a number of different types of investments (US and foreign stocks and bonds, different types of bonds, real estate, alternative strategies, and more), and most funds invest in hundreds of issues at a time. “Asset allocation” funds might invest in all of those types of investments, exposing you to thousands of issues with one vehicle.

Wrong Place, Wrong Time

This is the first reason that everybody gives for diversifying: you don’t want to have all of your eggs in one basket. If something bad happens to whatever you picked, you’ll suffer steep losses. By spreading things around, one or two investments losing money won’t drag down your entire portfolio.

Of course, that assumes that only a few of your holdings will see losses at any given time. If everything goes down at once, you’re out of luck, and that is where diversification comes up a little bit short: some people believe that it can protect against losses, but all it can do is improve your chances. If you want an example, see 2008 when pretty much everything lost money at the same time (stocks, most bonds except US government bonds, US stocks, foreign stocks and bonds, real estate, and so on).

Right Place, Right Time

A more optimistic view of diversification might say that it can put you in the right place at the right time. You might have some great ideas, but you can’t know everything. If you only invest in what you think will do well, you’re closing the door to a lot of opportunities. In fact, investors often avoid investments that are out of favor, only to see those investments do well. The assumption is that if it’s been doing poorly, it’ll continue to do poorly. Sometimes that’s true, and sometimes it’s not.

It doesn’t make sense to invest in anything that you think will lose money, but you need a good reason to avoid areas that are considered “textbook” investments (again, all of the types of investments mentioned above). It’s also risky to time the market: saying that markets are too high right now (instead of continuing to invest according to your long-term plan) can cause problems.

A Free Lunch

In general, you can only expect higher returns if you take more risk. Not interested in risk? That’s fine, there are plenty of safe investments out there – maybe you don’t really need to earn high returns to reach your goals.

Everybody wants to earn high returns while taking very little risk. It’s not possible of course, but there are a few ways to manage your risk. Diversification gives you what is probably the only “free lunch” when it comes to the risk-reward tradeoff: diversifying can bring higher returns with lower risks.

The math is complex, but here’s an example (no, you’re not Yale, but as the article mentions you can use a variety of “alternative” ETFs and mutual funds to get similar results). By combining investments with different characteristics – some of them zig while others zag – you can lower your risk while increasing returns. The amount of risk reduction and return enhancement might not be staggering, but it’s better than nothing. If you’ve got a tool available, why not take advantage of it?

When you diversify you won’t make a killing, but you’re a little less likely to get killed in the markets.

Photo credit: bigbrand