You’re often told to diversify, but you may interpret that advice narrowly. You might own several mutual funds, yet those funds can still hold overlapping securities. Or you might diversify across industries but overlook other crucial dimensions like geography, asset class, and company size.
The basic principle of diversification
Diversification works because not all investments are likely to move in the same direction simultaneously. If one investment is underperforming, another may hold steady or do well. This interplay smooths out returns and lowers the risk of catastrophic losses.
Harry Markowitz, who won the Nobel Prize in Economics for his work on Modern Portfolio Theory, called diversification “the only free lunch in investing”.
Beyond basic diversification
For many, diversification stops at owning a handful of large-cap U.S. stocks or mutual funds that hold them. This approach leaves portfolios vulnerable to sector-specific or market-wide downturns. Proper diversification involves spreading investments across:
- Asset classes (stocks, bonds, real estate, commodities)
- Geographic regions (U.S., developed international, emerging markets)
- Company sizes (large-cap, mid-cap, small-cap)
- Investment styles (value, growth, quality, momentum)
A well-diversified portfolio incorporates these elements in proportions aligned with your goals, time horizon, and risk tolerance.
Reduce volatility without sacrificing returns
A common misconception is that diversification means accepting lower returns. Diversification can help investors maintain similar or even better returns with less volatility. The performance of a global 60/40 portfolio has been remarkably consistent over time.
Steady, consistent performance means you are less likely to panic during downturns and sell at the wrong time. This behavioral benefit alone can significantly improve long-term outcomes.
The role of correlations
The effectiveness of diversification depends on the correlations between your investments. Correlation measures how closely two assets move together. If two assets are perfectly correlated (a correlation of +1), they will move in the same direction and to the same degree, offering no diversification benefit. If they are perfectly negatively correlated (a correlation of -1), one will rise in the same percentage as the other falls.
In practice, correlations are rarely perfect. The goal is to combine assets with low or moderate correlations to complement each other in different market environments.
Why global diversification matters
Investors in the U.S. sometimes assume that sticking with domestic investments is safer. While the U.S. has historically been a strong market, it does not always lead. Between 2000 and 2009, often called the “lost decade” for U.S. stocks, the S&P 500 was flat. During the same period, emerging markets outperformed US stocks by almost 10% annually!
Global diversification helps you capture returns from markets that may outperform when your home market is struggling. It also reduces the risk associated with economic or political issues concentrated in one country.
Diversification across asset classes
Stocks may offer higher expected returns, but they can be volatile. Bonds typically provide lower returns but offer stability and income. Real estate can provide income and inflation protection, while commodities can hedge against certain economic shocks.
By blending different asset classes, you build a portfolio that’s less reliant on the performance of any single investment, helping to smooth out volatility.
Avoid hidden concentration
One of the most common diversification pitfalls is hidden concentration. Many mutual funds and ETFs hold similar underlying securities. You might think you are diversified by holding an S&P 500 index fund, a large-cap growth fund, and a tech sector fund, only to discover that all three are heavily weighted in the same large technology companies.
The cost of under-diversification
Under-diversification can expose you to unnecessary risk. A portfolio heavily invested in one sector, like technology, may perform exceptionally well during certain periods but can suffer significant losses when the sector underperforms. From 2000 to 2002, the Nasdaq Composite fell by almost 78% from its peak, devastating concentrated tech investors.
Even if you have strong convictions about a sector or stock, it should represent a disciplined weight of your overall portfolio.
Rebalance to maintain diversification
Over time, market movements will cause your portfolio allocations to drift from their targets, resulting in unintended risk exposure. Rebalancing—periodically selling some of the outperforming assets and buying more of the underperforming ones—helps maintain your intended risk profile and diversification.
Rebalancing can also be a systematic way of selling overpriced and buying underpriced assets without trying to time the market.
When diversification may fail
In 2022, financial markets experienced significant volatility due to several factors, including rising inflation, central bank interest rate hikes, and geopolitical tensions, particularly the ongoing war in Ukraine.
As the Federal Reserve and other central banks aggressively raised interest rates to combat inflation, both equities and fixed-income securities sold off simultaneously, leading many investors to realize that traditional diversification strategies were less effective during this period. This dynamic underscores the importance of understanding market environments and how they can affect the performance of different asset classes.
Overall, 2022 reminded us of how interconnected global markets can be during stressful periods, highlighting the challenges of managing risk and maintaining portfolio stability in volatile times. However, even in these periods, certain assets, like high-quality bonds, may still hold their value or even appreciate. The key is to set realistic expectations: diversification reduces risk but does not eliminate it.
The long-term payoff
Investing is about probabilities, not certainties. Diversification shifts the odds in your favor by reducing exposure to any single point of failure. Over decades, this can mean steadier compounding, smaller drawdowns, and a greater likelihood of meeting your financial goals.
Broad diversification isn’t about owning hundreds of securities. It’s about owning the right mix of investments likely to behave differently in varying conditions. That mix will be unique to your goals, resources, and risk comfort.
If you want your money to work for you without keeping you up at night, diversification is one of the smartest strategies you can employ.
