Why Portfolio Diversification Is Vital to Investing Success

Portfolio diversification provides the closest thing to a free lunch available to investors.

Aug 13, 2014 at 1:46PM

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 investments.

Roulette
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 20%.

Indeed, as you split your money across investments in that world, your expected return never changes, but your probability of losing everything drops off dramatically. The table below shows the details:

Number of Investments

Expected Return

Probability of Losing Everything

1

10%

45%

2

10%

20.25%

5

10%

1.8%

10

10%

0.034%

20

10%

0.000012%

Based on author's calculations. Does not reflect a real-world scenario.

Mathematically speaking, the chance of losing everything in that example never goes entirely 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 worth pursuing.

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 (NYSEMKT:VT), 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 investments.

If you're do-it-yourself type of investor, you can build your own portfolio with an eye toward diversification. The keys to success include:

  • Consider the potential of each of your investments individually. 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 countries. 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 "diworsification" -- i.e., worsening your risk-return trade-off by holding too many assets that have similar correlations.Diversification only 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 within asset classes as well. Buying another stock for diversification's sake, for instance, does you no good if the company behind that stock is on the road to bankruptcy liquidation.

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 return.

What are you investing for?
The largest expense most investors are saving for is their own retirement. A diversified portfolio can certainly play a key role in your financial security, but it's not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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