The great value investor Benjamin Graham likened the market to
a giant roulette wheel and stressed the importance of portfolio
diversification in protecting your overall capital at risk in
Source: Conor Ogle via Wikimedia commons.
Portfolio diversification is a strategy of buying and owning
unrelated or uncorrelated assets in your investment accounts. The
objective is to reduce the risk to your total portfolio from the
catastrophic loss of any single asset.
Portfolio diversification cannot improve your overall expected
investment return, but done well, it can improve your chances of
getting total portfolio returns closer to that expected level.
Because it has the potential to lower your overall risk of
disastrous losses without reducing your expected returns,
portfolio diversification has been called "
the closest thing to a free lunch
" in investing.
The concept behind portfolio diversification
Imagine a world where every investment acted completely
independently of every other investment but behaved like a spin
of a giant roulette wheel with exactly two possible outcomes:
- 55% chance of doubling
- 45% chance of dropping to zero
If you invested all your money in exactly one spin of that
roulette wheel, your portfolio's expected return would be 10%,
but your chances of losing everything would be 45%. Split your
money across two spins, and your expected return would still be
10%, but your chance of losing everything drops to closer to
Indeed, as you split your money across investments in that
world, your expected return never changes, but your probability
drops off dramatically. The table below shows the details:
Number of Investments
Probability of Losing Everything
Based on author's calculations. Does not reflect a real-world
Mathematically speaking, the chance of losing everything in
that example never goes
away, but it sure does diminish quickly. Given a choice between
making one investment and making 20, which would you prefer?
In the real world, the numbers aren't so simple, and
investments do not act completely independently of each other.
Additionally, things like currency fluctuations, changes in laws
and regulations, and financial system meltdowns can create
dislocating events in which formerly unrelated investments
suddenly start moving together. Still, the concept of portfolio
diversification generally holds well enough in practice to be
How do you practice portfolio diversification?
The easiest way to diversify your portfolio is through
diversified funds. For example, Vanguard offers the
Total World Stock ETF
, an exchange-traded fund that covers about 7,250 stocks across
countries, sectors, and market capitalizations. And of course,
you can achieve even more diversification by investing beyond
stocks. You can add bonds, commodities, currencies, artwork, and
collectables, just to name a few, to further diversify your
If you're do-it-yourself type of investor, you can build your
own portfolio with an eye toward diversification. The keys to
Consider the potential of each of your investments
Diversification won't help your expected returns, so you need
to make sure each of your picks makes sense on its own.
Invest across several industries and
Buying 10 different domestic banks' stocks won't protect your
portfolio from the next American financial meltdown.
Invest across asset classes.
Just make sure each investment individually looks capable of
playing its part in helping you reach your portfolio's overall
expected rate of return.
Watch your position sizes.
Consider would happen to your portfolio if an industry you
invested in were suddenly regulated out of existence.
Is there a downside to portfolio diversification?
The downside is that diversification can quickly morph into
what noted investing guru Peter Lynch called "di
ification" -- i.e., worsening your risk-return trade-off by
holding too many assets that have similar
provides its "free lunch" benefit to the extent that each of your
investments is truly priced for a similar -- and reasonably high
-- expected return. Once you introduce assets with lower expected
returns into your portfolio, your portfolio's total expected rate
of return will drop, even if those assets reduce the potential
impact of a massive single loss.
For instance, if stocks have an expected 10% return and bonds
have an expected 4% return, a 50% stock and 50% bond portfolio
would have an expected return of 7%. In that example, the
diversification benefit of investing across multiple asset
classes didn't come for free; it came with the real cost of a
reduced expected return rate.
The same risk of turning portfolio diversification into
diworsification is present
asset classes as well. Buying
stock for diversification's sake, for instance, does you no good
if the company behind that stock is on the road to bankruptcy
Despite the potential downsides, a well-constructed portfolio
built with intelligent diversification in mind can do wonders.
Nothing else works so well for simultaneously reducing your
overall risk and helping your portfolio achieve your expected
What are you investing for?
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Why Portfolio Diversification Is Vital to
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