Understand Risk Before You Diversify

Before investors can use diversification to maximize investment returns, they need to understand the two types of investment risk: unsystematic risk and systematic risk.

Unsystematic vs Systematic Risk

Unsystematic risk can be diversified away by constructing a portfolio of securities that, at a basic level, are different or non-correlated. For example, if an individual had a portfolio with only one type of stock, the portfolio carries a large amount of unsystematic risk.

The portfolio isn't maximizing returns for a given level of risk because the risk associated with having one type of stock can be taken away simply by adding another stock to the portfolio. By selling half of the single company's stock and purchasing stock in a different one, the investor reduces their unsystematic risk because their portfolio now contains two different companies in different sectors with different financials.

On the other hand, systematic risk, also known as market risk, can't be diversified away. For example, investors can't control the overall market and its fluctuations on a day-to-day basis, interest rates and whether they will go up or down, or inflation. These are all part of systematic risk.

The goal of an investment manager is to reduce the risk within their control to a level aligned with the investor's tolerance of their investments to decline in value, and their need to achieve a particular return for stated goals. It's important for investors to determine what level of risk they are comfortable taking, what risk may be necessary to achieve their goals and to communicate this information to their investment manager.

Why Diversification Matters

Now let's focus on why diversification matters. In our previous example, an individual's entire portfolio consisted of one company's stock. That individual is also employed at the company and receives a salary in addition to the stocks awards he receives as part of his compensation.

From the individual's perspective, they may not see the risks associated with his cash flow and stock assets all coming from his employer. But if an unfortunate situation occurred where he lost his job, or a disabling accident occurred, his entire financial situation would be upended.

Alternatively, if he sold at least some of his company's stock and invested in a diversified portfolio of ETFs and index funds, he'd have a much safer cushion to fall back on if something happened. But what if the company stock is rocketing upwards? A diversified portfolio often does just as well when compared to the majority of individual stocks. Just because a particular stock is up 20% year over year doesn't mean the rest of the market isn't. For example if the individual invested in an index fund of the S&P 500 in 2017, he would have earned roughly 21% while still diversifying his risk across several companies. (For related reading, see: The 4 Best S&P 500 Index Funds.)

Reducing Volatility

Diversification reduces the overall volatility of a portfolio. Asset classes experience different stages of the market cycle at different times. In the case of 2008, the last market recession, a diversified portfolio was down 26% on average compared to large-cap growth stocks (S&P 500), which were down 38%. As diversified portfolio consistently performed in the middle of all asset classes.

Why Diversify If It Won't Earn Me the Highest Returns in Any Given Year?

Over time, the compounding of consistent returns and reduced volatility of a portfolio can potentially result in a greater portfolio balance than only investing in one asset class. However every investor is different and past performance does not guarantee future returns. If an investor is comfortable investing in stocks only, his method of diversification may be through owning stock in different sectors, market caps and geographical locations instead diversifying into bonds or alternative investments.

Diversification helps take the unknown out of trying to pick the best performing asset class on a year-to-year basis, and instead focuses on maintaining consistent, less volatile and somewhat predictable returns over long periods of time. In the process of building wealth, taking calculated risks through concentrated positions isn't necessarily a bad thing, as long as you understand the risks. (For related reading, see: How to Manage the Risk of Your Own Portfolio.)

Many of the world's richest people earn their wealth through concentrated positions in their own business or a particular stock. However, for the vast majority of people, it's not feasible, nor can they tolerate the risk involved with such investments. If investors can't sleep at night because they're worried about all their hard-earned money being reduced by 10% (defined as a market correction, a natural part of the market cycle) what's the point?

Having a diversified portfolio can grow into significant wealth with time, compounding and discipline, providing enough income to achieve the goals and life envisioned if the necessary steps are taken to achieve them. Managing risk, diversifying the investment portfolio, and knowing what's needed to reach individual goals are all part of an effective financial planning process. 

(For more from this author, see: The Best Way to Budget: Automate Your Finances.)