You’ve heard that you should be diversified, but do you know why? Diversification reduces your risk and your volatility. Here’s how.
Diversification Reduces Risk
This aspect of diversification is simple. By spreading your portfolio out among several investments, you reduce the total amount committed to any one investment. If you evenly split your portfolio between 5 investments and one goes down the drain, you’ve still got your other 4 investments to fall back on. If you’d put everything in that one bad investment, you would have nothing left.
In this sense, diversification is putting your eggs in different baskets. By not betting everything on one investment, you lessen the risk of losing everything all at once.
Diversification Reduces Volatility
Volatility is that nasty stuff that makes your investments go up and down until you can’t stand it anymore. But you can reduce the volatility of your portfolio by diversifying among investments that don’t all move the same. (Technically, you would say you’re investing in assets that are not “correlated”. It’s possible to be very diversified without reducing volatility. We’ll assume that your diversified investments include assets that are not correlated.)
When one investment goes up, another might be going down. Your portfolio will do something in between. An illustration can help you see how this works. We’ll use just two investments in our sample portfolios to keep this simple. If your investments move in the exact same way, diversification won’t help. This is because your investments are correlated. “Perfect correlation” looks like this:
As you can see, investments A and B move in lock-step. When one goes up, so does the other. This means your portfolio will also move in exactly the same way. You haven’t reduced your volatility.
The best scenario possible is that your investments are perfectly non-correlated. This means that one always goes up when the other goes down and vice versa. If your portfolio was invested in two investments like this, you’d get a constant return all the time. “Perfect non-correlation” looks like this:
The only problem is you’ll never find a real investment C and D. Perfect non-correlation doesn’t exist in the real world. The best we can do is “non-correlation”. In this case, some investments generally move opposite of others (but not always) OR they generally move the same direction (but not always). Here’s what non-correlation looks like:
An example of investments E and F might be stocks and bonds. Generally, they don’t move together but sometimes they do. A real-world portfolio is going to look something like the dotted line in that last chart. It’ll have some volatility, but not quite as much as its individual components. This is the goal of good diversification – spreading out risk while using assets that aren’t correlated.
Good Diversification Means Investing in Different Types of Assets
As I pointed out before, you can be “diversified” but still not reduce your volatility. If you invest in ten different banks but the financial industry goes down, your portfolio is going to go down despite the fact that you’ve “diversified” your money by not putting it all in one stock.
But if you want good diversification – the kind that reduces your volatility – then you need to invest in different kinds of assets. You’ll want stocks from different industries and different countries, large companies and small companies, growth stocks and value stocks. Then you’ll want assets that are different than stocks – real estate, bonds, commodities, etc. By mixing all of these together, you’ll have a portfolio that reduces your risk and your volatility at the same time.
If you want to see what a diversified portfolio might look like, check out my free portfolio allocation calculator. It shows you how to split up your investments using Vanguard mutual funds (because that’s the cheapest, most effective way to get good diversification easily). Try it out!