What Is Diversification?

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

The Basics of Diversification

Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently (often in opposing ways) to influences that drive the markets.

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities yields further diversification benefits, albeit at a drastically smaller rate.

Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Classes can include stocks and bonds, real estate, exchange-traded funds (ETFs), commodities, and short-term cash-equivalents. They will then diversify among investments within the assets classes, such as by selecting stocks from various sectors that tend to have low return correlation, or by choosing stocks with different market capitalizations. In the case of bonds, investors can select from investment-grade corporate bonds, U.S. Treasuries, state and municipal bonds, high-yield bonds and others.  

Investors can reap further diversification benefits by investing in foreign securities because they tend to be less closely correlated with domestic ones. For example, forces depressing the U.S. economy may not affect Japan's economy in the same way; therefore, holding Japanese stocks gives an investor a small cushion of protection against losses during an American economic downturn.

Diversification and the Retail Investor

Time and budget constraints can make it difficult for noninstitutional investors—i.e., individuals—to create an adequately diversified portfolio. This challenge is a key reason why mutual funds are so popular with retail investors. Buying shares in a mutual fund offers an inexpensive way to diversify their investments.

While mutual funds provide diversification across various asset classes, exchange-traded funds (ETFs) afford investor access to narrow markets such as commodities and international plays that would ordinarily be difficult to access. An individual with a $100,000 portfolio can spread the investment among ETFs with no overlap.

Say an aggressive investor wishes to construct a portfolio composed of Japanese equities, Australian bonds, and cotton futures. He can purchase stakes in the iShares MSCI Japan ETF, the Vanguard Australian Government Bond Index ETF, and the iPath Bloomberg Cotton Subindex Total Return ETN, for example. The specificity of the targeted asset classes and the transparency of the holdings ensure true diversification, with divergent correlations among securities, can be achieved.

Disadvantages of Diversification

Reduced risk, a volatility buffer: The pluses of diversification are many. But there are drawbacks, too. The more holdings a portfolio has, the more time-consuming it can be to manage—and the more expensive, since buying and selling many different holdings incurs more transaction fees and brokerage commissions.

More fundamentally, diversification's spreading-out strategy works both ways, lessening risk and reward. Say you've invested $120,000 equally among six stocks, and one doubles in value: Your $20,000 stake is now worth $40,000. You've made a lot, sure, but not as much as if your entire $120,000 had been invested in that one company. By protecting you on the downside, diversification limits you on the upside—at least, in the short term. Over the long term, diversified portfolios do tend to post higher returns (see example below).

Pros

  • Reduces portfolio risk

  • Hedges against market volatility

  • Offers higher returns long-term

Cons

  • Limits gains short-term

  • Time-consuming to manage

  • Incurs more transaction fees, commissions

Diversification and Smart Beta

Smart beta strategies offer diversification by tracking underlying indices but do not necessarily weigh stocks according to market cap. ETF managers further screen equity issues on fundamentals and rebalance portfolios according to objective analysis and not just company size. While smart beta portfolios are unmanaged, the primary goal becomes outperformance of the index itself.

For example, as of March 2019, the iShares Edge MSCI USA Quality Factor ETF holds 125 large- and mid-cap U.S. stocks. By focusing on return on equity (ROE), debt-to-equity (D/E) ratio and not solely market cap, the ETF has returned 90.49% cumulatively since its inception in July 2013. A similar investment in the S&P 500 Index grew by 66.33%.

Key Takeaways

  • Diversification is a strategy that mixes a wide variety of investments within a portfolio.
  • Portfolio holdings can be diversified across asset classes and within classes, and also geographically—by investing in both domestic and foreign markets.
  • Diversification limits portfolio risk but can also mitigate performance, at least in the short term.