How to Get a Free Lunch with Diversification

The closest thing to a free lunch when it comes to managing your money is diversification.  When done properly, diversification can help you achieve what every investor wants – returns with less risk. Unfortunately, the benefits often get lost in translation when put into practice.

What is Diversification?

Simply said, diversification is the process of spreading your (nest) egg across different baskets. It means holding uncorrelated or less correlated investments that zig while others zag as they grow over time. In my opinion, diversification is more about reducing risk than increasing returns. What it can do is smooth out the growth of your portfolio. A properly diversified portfolio can reduce the risk of being too heavily invested in one area when it performs particularly bad. Diversification does not guarantee against losses. Diversification does increase the likelihood that a portfolio will participate in gains, whenever and wherever they occur. This is because a well diversified portfolio casts a wide net to capture returns. Over time, a well diversified portfolio is a more resilient to market downturns.

You can think about baskets for your investments in many ways. Different asset baskets may be stocks and bonds. Location baskets may be US vs. International, California vs. New York, etc. Style baskets may be growth and value or active vs. passive money management. Account baskets may be taxable vs. tax-preferred accounts such as IRA and 401(k) accounts. How they differ defines why they zig and zag. They also affect the costs and taxes related to your portfolio.

In terms of assets, you should expect different return profiles between stocks and bonds. Shareholders of a company’s stock own a part of a company. They expect to participate in the company’s future growth. Bondholders lend money to borrowers such as companies and governments. Instead of future growth, bondholders expect to earn interest and get their money back when the bond matures. Either stock or bond Investments may lose money. In practice, the two are not always so clear cut. Some stocks have return profiles like bonds, and some bonds have return profiles like stocks. It is always good to review and have some understanding of what you own.

How Diversified is Your Portfolio?

There are simple ways to gauge the diversification of your portfolio. Start by looking to see if a small handful of your holdings represent a large portion of your portfolio. Depending on your personal situation, flags should go up when you see a single holding account for more than 10% (lower to be more conservative). Also see if your portfolio has any concentration in any sectors, industry, high/low risk, fast/slow growth segments, etc. For the more ambitious, review the correlation of the holdings. Correlation, which ranges from -1 to +1, describes the relationship between the returns of two investments. Ideally, a diversified portfolio holds un- or less-correlated, which is why stocks and bonds are often mentioned together.

Surprise, Surprise

When I review a portfolio for someone, a lot of people get surprised when I tell them that their portfolio is very risky. They may hold many different stocks, for example, but a portfolio with mostly high growth companies is generally not very diversified. Some hold many mutual funds. That may sound like diversification, but not if there is much overlap in the different funds. Another surprise is when people learn that the correlation of their holdings changed over time. What was once uncorrelated may have become much more highly correlated over time.

There are many tools on the internet or your employer’s retirement plan that can help you get started with diversification. You can reduce the risk of your portfolio for very little cost with simple decisions about diversification, making it the closest thing to a free lunch you can get in investing.