3 Ways Diversification in Investing Reduces Your Risk (2024)

The next element to cover in our Investing for Beginners series is Diversification in Investing. Diversification is magical, helping to reduce the overall risk, or volatility in your investment portfolio, without necessarily giving up significant returns. Think of it as smoothing your portfolio performance over time. Read on to learn what diversification is, how it works to eliminate various elements of investment risk, and see how it works in action.

What is Diversification in Investing?

You all know the saying - "Don't put all your eggs in one basket." Diversification is essentially what you do to avoid putting all your eggs in one basket. Diversification in investing is a way to manage risk by investing in a mixture of different investments and asset classes in order to limit your exposure to any single company, asset class or risk. In plain English, instead of putting all your money in Apple, or even all your investment funds in an S&P 500 ETF, you might hold a few individual stocks, large cap, small cap and global equity index funds, and bond indices as well.

3 Ways Diversification in Investing Reduces Risk

There are 3 specific types of investment risk that you can help to reduce through diversification: concentration risk, correlation risk, and inflation risk.

Concentration Risk

Concentration risk in investing comes from when an investment or group of investments have exposure to a single company, industry, or even asset class. The risk of concentrating your investment portfolio is that if that one company, industry or asset class Imoves in an unfavorable direction, the loss may be significant or lost entirely.

Diversifying your investments among different companies, industries, and asset class reduces concentration risk.

Correlation Risk

Correlation is a statistical measure of the relationship between the price movements of different investments within a portfolio. Some investments have greater correlation to one another than others. For example, companies in the same industry, like Facebook and Google, may be more correlated than companies in two different sectors, like Facebook and Exxon. Investments in the same asset class, like two different stocks, may be more correlated than investments in different asset classes, like stocks and bonds.

Diversification in investing works most effectively when you choose investments for your portfolio that have low or negative correlation. This is so that when some parts of your portfolio may be falling, others are rising. This helps smooth the ups and downs, and reduce the overall volatility, or risk, in your portfolio.

Inflation Risk

Higher inflation is a more pressing investment concern in the current environment. Inflation, or rising prices, can reduce your overall investment returns due to a decline in purchasing power. Bonds have the highest inflationary risk because their coupon payments are typically set at a fixed interest rate, though they are useful part of diversification in investing due to their typically inverse correlation with stocks.

Holding both stocks and bonds, as well as asset classes like Real Estate, and TIPS - Treasury bonds indexed to inflation to explicitly protect investors from inflation, in your portfolio aid in reducing inflation risk.

What Does Diversification in Investing Actually Look Like?

When I explain what diversification does - how it helps to reduce various risks - it can still seem pretty abstract. So, what does it actually look like in practice? I'm going to lay out a series of investment options, and how how varying combinations of them perform in a portfolio overtime. Note how the annual investment return, and more importantly, the volatility of each portfolio changes.

Recall that volatility is how we measure risk in finance. It's how much your investment moves up or down relative to its average return over time. When it comes to investing, the ultimate goal should be to generate the best risk-adjusted returns. We all would love to invest and earn 30% a year - but we don't want 30% volatility, with our investment portfolio potentially being down as much as 30-60% every year either. Most people don't have the stomach for that.

Investment Choices

First, let's look at a range of investment choices and how they performed over the last 15 years, through the Great Recession and the current recession as well. What would you want to put in your portfolio? Keep in mind, it's always easier to say Stock A, with the benefit of hindsight and it's stark outperformance. I've removed it from the second chart so you can better see how other investment choices performed.

Portfolio Combinations

Now, let's look at a few different investment portfolio combinations, with varying levels of diversification and some without. In each case, it looks at the value of investing $100 at the end of 2004. Each portfolio graph also shows the timing of both the Great Recession and current recession, as well as the 10-Year Treasury yield, so you can see how the portfolios perform through different and changing interest rate environments.

First up, let's say you do put all your eggs in one basket, and invest everything in a single stock.

If you put all your money in Stock A at the end of 2004, you would have earned a 34.6% annualized return, but with 32.5% volatility. You would also have had to stomach a 57% decline in your investment during the Great Recession. You could also just as easily have chosen Stock B, with far lower returns, but also less volatility. In either case, with some diversification in investing you can do better.

Let's say you opt to skip single stocks entirely, and put all your money in a major stock index. There's some benefit of diversification, given you're invested in a large basket fo stocks, but no asset class diversification.

Look at the results... you generate a better-annualized return than investing everything all in Stock B, while also significantly reducing your volatility. This is what we mean by diversification reducing risk. But there's still a more than 50% drawdown during the Great Recession. Let's see if more diversification helps soften that a bit.

Alright, what if I add some asset class diversification into the mix too. Here's what it would look like if you took your $100 at the end of 2004, and put $80 into a major stock index and 20% into a bond index.

You lose a little bit in annualized returns, but a 9.0% annualized return is nothing to sneeze at. At the same time, you've reduced your volatility even more, and reduced the drawdown impact during the Great Recession too. See how in both recessionary periods your bond index investment ticks up at the same time your stock index investment falls?

What if we add a little more diversification to the mix... and I'll even tell you what the investments are this time too. Here, you put your $100 at the end of 2004 into an S&P 500 ETF (50%), a Russell 2000 Small Cap ETF (20%), an MSCI World ex US ETF (10%) for some global exposure, a 20+ Year Treasury Bond ETF (15%), and that leaves you 5% to play with in individual stocks you might want to take a chance on. Let's say you get lucky and picked Apple.

You've added some volatility back in with the single stock, but it's also added some significant performance as well. And you've still offset some of the drawdown in the Great Recession too.

What if you make that 5% stock bet and it goes belly-up, amounting to nothing?

An 8.4% annualized return still isn't bad, and your low double-digit volatility is tolerable too. And you have to realize risk of a complete loss is a risk when you invest in a single, highly volatile stock - they don't all end up being Apple.

How Should YOU Diversify Your Investment Portfolio?

Only you can answer this. Only you can gauge what your risk appetite is, and your risk appetite typically changes, getting less and less the closer your get to your investment goal. If you are saving for retirement in your 20s, you can afford to take on more volatility to ride out downturns for higher returns over time. If you have more appetite for risk, you can throw in a few single stock names, or more speculative investments, like Bitcoin, as a small component of your total investment portfolio. But as you get closer to retiring in your late 50s and early 60s, you likely want less volatility in order to have more certainty around your portfolio balance as you enter retirement.

The same idea applies to saving for your child's college fund in a 529 Plan. When your child is a baby and 18 years away from going to college, you can invest more heavily in stock index funds, with higher volatility, to help your investment grow more quickly, then shift to a more stable, less volatile mix as they approach high school graduation and actually going to college.

What if you don't want to mess with choosing stocks, indexes are worry about balancing your portfolio appropriately overtime? Coming up next in the How to Start to Invest series... Target Date Funds. What are they, how do they work, and whether they are a good investment choice for your portfolio.

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