The idea of having a diversified investment portfolio, part of Harry Markowitz’ Nobel Prize winning modern portfolio theory (MPT), is so ingrained in the minds of investors today that sometimes even the most experienced people who play the market fail to consciously take diversification into account when making buy and sell decisions.
Risk And Return
The whole thing is built on the notion that risk and return are related. Traditionally, to get a higher return, you must take on more risk. If you insist on less risk, you must expect a lower return. Within the boundaries of that basic concept, however, lies a ton of variability. In fact, variability is key. To get a higher expected return you must have more variability in your portfolio. Less variability will cost you in expected return. At least that was the case until Markowitz.
Markowitz showed through research that by building a portfolio with investments that behave differently from one another, it’s possible to lower variability without sacrificing return. Through diversification you can receive the benefit of lower portfolio variability without giving anything up. Put another way, by spreading your investments among as many different companies as possible you reduce risk, period.
If you could pick the winners all the time, investing would be easy. Returns are driven by a small number of stocks that perform well. Unfortunately, you can’t know who the winners will be ahead of time. By extension, since you can’t know who the winners will be, the more companies you invest in the great the chance you will pick a winner by sheer volume of choice. Fortunately, in today’s world of index funds it’s possible to own nearly everything and therefore virtually ensure you will own the winners almost all the time. Yes, you will also own some losers and that will temper your gains. Picking a few stocks and making bad choices results in such a terrible outcome, it’s simply not worth it.
Types Of Risk
There are two main types of investment risk, undiversifiable and diversifiable. Undiversifiable risk is also known as "systematic" or "market risk." It’s associated with all companies and is caused by things like inflation rates, exchange rates, political instability, war and interest rates. Undiversifiable risk (by definition) can’t be mitigated through diversification. For most investors, undiversifiable risk is just risk you must accept.
Diversifiable risk, on the other hand, is a type of risk that diversification can affect. It’s also known as "unsystematic risk" and is specific to a company, industry, market, economy or country. Diversifiable risk can be reduced through diversification because it is typically caused by business or financial risk. By investing in a variety of assets, you can avoid the specific business or financial risk associated with a single company.
Reasons To Diversify
Suppose you only own stocks in a specific sector such as airlines and there is a strike of airline pilots. Your portfolio lacks diversification and while the strike is on your stocks will drop in value. If you diversified, for example, by owning a couple of railroad stocks, only part of your portfolio would be affected by the airline strike. If you diversified even further by adding other, non-travel sectors, your portfolio would be even less risky. Investing in different asset classes – i.e. stocks and bonds – would provide even more diversification and even less risk.
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How Much Is Enough?
It isn’t necessary to own stocks in every company, sector and asset class known to man (although you can come close with certain index funds). Experts suggest that optimal diversification can be had by owning no more than 15 to 20 stocks spread across various industries along with bonds or bond funds to provide asset class variety. In fact, some analysts believe it is possible to over-diversify and generate smaller returns.