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Diversification is a buzz word that gets thrown around a lot in the finance world. But does everyone really know what diversification is?
I think most probably know the high level definition: diversification is not putting all your eggs in one basket. It is spreading out your investments across different investment vehicles so that if one part of your portfolio goes down, hopefully others can cover it.
But what about the nitty gritty details of diversification?
Like how you can be diversified across sectors, through different asset classes, and internationally.
Or how to know if you are actually achieving diversification in your portfolio?
That’s what we’ll be diving into in this article. We’ll go a bit more in depth that we usually do, but at the end simplify it down for you so that you can easily take action to build your own diversified portfolio.
What is Diversification? The Detailed Definition.
As mentioned previously, diversification is the strategy of holding multiple types of investments that are negatively correlated to reduce the risk in your portfolio.
In other words, it involves holding investments that do not all move in the same direction at the same time.
The most basic example involves stock and bond diversification. While stocks generally perform better in the long term, they can be volatile in the short term. On the other hand, bonds tend to underperform stocks over the long term, but provide more consistent returns.
The chart below shows the performance of the S&P 500 (blue) and a Vanguard total bond fund (pink). As you can see, over the course of 2006-2013, stocks (the S&P 500) performed better in the long term but were very volatile – especially in 2008.
Bonds on the other hand held steady. And while their yield changed throughout the years, their underlying principle value did not waver dramatically.
Though, there are multiple ways to achieve diversification beyond just holding stocks and bonds. Here are a few to know:
The first and most common form of diversification is asset diversification. This includes the stock and bond example above, but also other asset classes and investment vehicles such as:
- Index Funds / ETFs
- Real Estate
Having a wide variety (or the right variety) of these assets will help in building a strong portfolio.
Investing in various sectors can also help mitigate risk in your portfolio. Sectors are generally viewed as business sectors (useful when choosing stocks and equity funds), and include:
- Consumer Products
- And much more…
Luckily, with the rise of index funds, it’s easy to properly diversify your portfolio across a huge range of stocks and sectors with only one investment.
Like with sector diversification and stocks, the same exists for bonds. There are a wide variety of types of bonds out there, which include:
- Corporate bonds
- Government bonds
- Treasury Bonds (like TIPS)
- Junk Bonds
- And much more…
Once again, thanks to index funds you can usually get a wide variety of bonds in your portfolio with one purchase.
Investing in international companies is another way to bring variety to your portfolio.
There are generally two options when investing internationally with equities:
- General International Funds
- Emerging Market Funds
Of course, you can niche down more than that if you would like – investing only in China, for example.
Usually though, when shopping for index funds, they are split into those two buckets. And both can be good options for achieving international diversification.
And much more…
As you can see, there are multiple ways to diversify your portfolio. Every time you move down one level in detail, there are more and more ways to become diversified.
Within bonds, there are also various grades (from AAA to C). With the better (AAA) bonds usually yielding less than the more risky (C) bonds.
Within stocks, there are stocks that pay dividends, and ones that don’t.
And the list goes on and on.
So how do you know if you are diversified the right way? And diversifying against the right set of rules?
That leads us to our next point… how do you achieve diversification?
How to Achieve Diversification?
Somewhat surprisingly, there is no universally accepted formula to measure diversification.
Instead, there are many theories and calculations that different investors, institutions, and advisors use to attempt to measure (and achieve) diversification.
Though, in general, all theories tend to agree on one thing: achieving diversification means having the best possible returns for a certain amount of volatility (risk).
In other words, diversification means you have built the portfolio that will provide the greatest returns for the amount of risk you want to take on.
Breaking that down, diversification has two parts you need to measure and optimize:
- Risk (volatility)
Measuring returns is easy.
Measuring risk (volatility) is slightly harder. Keeping it simple, to build a low risk portfolio, you want investments that are not correlated.
If all of your investments were correlated, it means they would all move in the same direction when new news hit the market. There would be huge volatility one way or the other.
With uncorrelated investments, when one investment goes drastically down, the other should go slightly up (or stay stable). Keeping your total portfolio more stable (and less risky).
So, to achieve diversification you want to have a portfolio of uncorrelated investments that provide the best possible returns.
If you want to get more into the details on how exactly to measure diversification, here are some good resources:
- Investopedia: Investopedia explores the Modern Portfolio Theory for achieving diversification.
- Betterment: Betterment walks through how they measure diversification in the portfolios they manage [Learn how to start investing with Betterment today]
- Seeking Alpha: Seeking Alpha shows examples to help bring diversification to life.
Building a Diversified Index Fund Portfolio
In this article we dove into the details a little more than we usually do. But that is because diversification is an extremely important topic for all investors to understand.
Bringing it back for the simple, index investor though, below walks through why index funds are still the best way to build a diversified portfolio.
Why Index Funds are Naturally Diversified
Back before index funds, many investors would buy 10, 20 or 100+ stocks in the hope that together they would provide steady returns. They would buy stocks of various sizes across various sectors to try to create a portfolio that performed how the S&P 500 or Dow Jones Industrial Average performs today.
Now, we can easily buy a Broad Equity Index Fund and become completely diversified in our equities with one investment. Index funds took the work out of becoming diversified.
You can even buy equal weight index funds if you want to take a slightly different approach to diversification.
The same goes for bonds and other types of investments.
You can quickly and easily buy a bond fund, or real estate fund, or other type of fund and become diversified across that asset class.
How to Combine Index Funds to Achieve Diversification
Now, say you want to own more than just stocks. Or bonds. Or real estate. You want to hold a variety of these funds to be fully diversified across asset classes.
The best and simplest way to do that is through a 3 Fund Portfolio (otherwise known as a lazy portfolio).
A 3 Fund Portfolio combines equities, bonds and international investments to create a fully diversified portfolio of index funds. It’s a great solution that is easy to manage!
You can learn more about 3 Fund Portfolios here.