What Is Portfolio Diversification, and Why Does It Matter?
- Mark Edwards ·
- 0 Comments ·
- December 23, 2018
You’ve no doubt heard that old cliché: “Don’t put all your eggs in one basket”. It’s meant to teach people the folly of entrusting all their possessions to single vehicle. After all, the handle could snap, or the bottom could give out, and you would be left with a messy pile of cracked eggs.
This is the same general principle behind portfolio diversification, one of the fundamental tenets of wise investing. If you want to learn to invest like the pros diversification is a good place to start, as it teaches you to spread your eggs – in this case, investments – across sectors, asset classes, etc., in order to reduce risk. Choosing investments that behave differently from one another helps mitigate the overall risk of a portfolio.
This article will look at what exactly is diversification and why it’s important, as well as how to diversify, and what limits are involved.
What Is Portfolio Diversification?
In a 1952 essay entitled “Portfolio Selection”, economist Harry Markovitz created what is called the Modern Portfolio Theory (MPT), a theory that formalized the idea of portfolio diversification. Essentially, Markovitz argued, holding combinations of investment instruments in one’s portfolio that aren’t perfectly positively correlated reduces risk. MPT has since been advanced and added to by other economists, but its initial iteration won Markovitz the Nobel Prize in Economics.
Put as a simple analogy – courtesy of this Rutgers article – you can liken it to a balanced diet. It’s healthy for your body to eat a diverse array of foods, as it ensures that you’re more likely to get all your nutrients. While eating spinach may be good for you, eating only spinach means risking nutrient deficiency. Likewise, investing in only one type of stick means risking loss of principal.
How to Diversify
The short answer on how to diversify your portfolio: spread your investments across asset classes, geographies, investment philosophies, etc. A somewhat more involved, and perhaps better way to diversify is to find a wealth management company that suits your needs and work out an investment portfolio with them, with an eye toward diversification.
The Limits of Diversification
It is important to note that diversification is not a guarantee against loss; it simply reduces the risk of loss. And there is certain risk that diversification cannot reduce or remove, called systematic risk, which is shock or loss faced by all investors in a market, not just a few. Events like weather catastrophes, geopolitical conflicts or recessions (like 2008’s Great Recession) affect the entire market, and therefore risk can never be completely eliminated through diversification.
This is, admittedly, a generalized overview of a vast and complicated subject. If you are looking to further empower yourself as an investor, get in touch with a wealth management service, who can put you in contact with an investment management company that suits your needs. But remember to weigh out a few different options – after all, you wouldn’t want all your eggs in one basket.