Quick Explainer, Diversification

It's intuitive to think that simply having more holdings in a portfolio would make it less risky. This isn't the case. A portfolio should hold assets that derive their return characteristics from different sources to lower its risk profile. This strategy is called diversification.

Our definition of diversification is:

Diversification: An investment strategy that combines holdings with different return drivers so that no single asset, sector, or strategy dominates a portfolio's outcome. Diversification does not ensure a profit or protect against loss.

Real diversification is about relationships between assets. When assets get their returns from similar places, it doesn't matter how many of them there are. When one performs poorly, they all perform poorly.

The way to measure this shared exposure is with correlation*. Some assets that look different at face value, like stocks and bonds, can actually move together in many market conditions.

The goal of diversification is to reduce the impact of any single event on a portfolio. By holding assets with different return drivers, portfolios can offset weak periods in one area with stronger returns from another, reducing the magnitude of swings. It also improves the risk-return tradeoff. A diversified portfolio can have a similar return profile to a concentrated one with less volatility.

Remember that diversification does not eliminate risk. A diversified portfolio can still be affected by broad market forces that impact all markets. It also doesn't guarantee profits since it's a risk management tool, not a return generator. It also doesn't replace careful investment selection. If an investor chooses poor-performing assets, correlated or uncorrelated, it's still a poor portfolio.

Where investors can apply diversification depends on the scope of risk they're trying to manage. Within domestic markets, a level of diversification can be found across sectors. For stocks, technology and consumer staples have different return drivers. For bonds, government debt acts differently from high yield corporate debt.

International versus domestic markets is another level, where geopolitical factors and currency moves create different return drivers. Higher still from that is broad asset class diversity. Stocks and bonds were long thought to be uncorrelated, but recent market cycles have shown they can move together. Adding commodities, real estate, and currencies broadens the spread of return drivers.

This can coalesce into a broad strategy that incorporates all of these assets in a systematic way to provide the level of risk-adjusted returns desired by the investor.

A well-diversified portfolio is one where holdings respond to different things, not just one where holdings look different. The count of investments matters less than the relationships between them. With no single asset providing the entire return, risk can be managed to reduce, but never eliminate, the chance that a single macro event will affect the entire portfolio in the same way.