So far, we know:
- Don’t pick individual stocks
- Don’t lose money
What does this lead to? Diversification.
Diversification is the strategy of having a broad variety of investments within a portfolio, by spreading investments over asset classes, sectors, industries, geographic regions, and individual companies.
This is perfectly exemplified by the age-old adage, “Don’t put all your eggs in one basket”.
Instead of investing your entire portfolio in only one or a few stocks, diversification involves investing a small amount in many different stocks.
Ray Dalio, renowned hedge fund manager, refers to diversification as the “Holy Grail” of investing.
The Purpose and Scope of Diversification
The purpose of diversifcation is as a risk management strategy, to maximize returns while minimizing risk.
In particular, it helps insulate an investor’s portfolio from the adverse impact of a poorly performing investment.
There are a few main types of diversification:
- Company diversification: To reduce the impact of negative events affecting any one particular company. This is called idiosyncratic risk, or company-specific risk.
- Sector diversification: Across industries such as technology, healthcare, real estate, energy, etc. This mitigates the potential loss if one of these sectors experiences a downturn, called sector risk.
- Geographical diversification: Across regions such as the United States, Canada, Europe, Asia, etc. This helps mitigate the negative impact of adverse events in any one country.
- Asset class diversification: Across different investment asset classes, including stocks, bonds, and cash.
Dispersion and Diversification
To understand why diversification is important, we have to understand how it affects dispersion.
Dispersion refers to the range or variability of possible investment outcomes (i.e. returns).
For example, one strategy might have a range from -40% to +60%, whereas another is -10% to +15%.
High dispersion indicates a lower reliability of your investment outcome, whereas low dispersion indicates higher reliability.
For long-term investors, low dispersion or high reliability is critical, because it maximizes the probability that your actual result will align closely with the long-term positive expected return of the stock market, and so of achieving your investment goals.
By spreading investments across a broad spectrum, diversification decreases the dispersion of returns, or in other words, decreases volatility.
Note: If you’ve studied statistics, future returns can be modelled by a random variable. This is because the future is unpredictable, or random. Then, returns follow a probability distribution, and dispersion is often measured by the standard deviation of the distribution.
Diversification not only helps maintain expected returns while decreasing dispersion, but it also enhances expected returns per unit of volatility or risk-adjusted returns.
There is a saying:
“Diversification is the only free lunch in investing”
This is because increasing investment diversification increase reliability without decreasing expected returns.
However, it’s crucial to note that diversification works best when the assets are at least somewhat uncorrelated, in that they don’t rise and fall together.
For example:
- Sector diversification: During the COVID-19 pandemic of 2020, technology stocks like Amazon, Apple, and Microsoft performed well, while sectors like travel, hospitality, and energy fell. Then, in 2021 and 2022, the energy sector performed well while the banking sector performed relatively poorly.
- Geographical diversification: From 1999 to 2009, the US market returned essentially 0% per year on avearge, called The Lost Decade. In the same time period, emerging markets (including China, Brazil, India, and other countries) returned about 10% per year on average. In the following time period from 2009 until 2023, the US market returned a staggering 15% per year on average, whereas emerging markets returned on about 5% on average.
- Asset class diversification: In the 1970s and early 1980s, there was high inflation and economic uncertainty, alternative assets like gold and commodities rose in value, while traditional stocks and bonds performed poorly. During the global financial crisis of 2008, as stocks collapsed, government bonds, particularly U.S. Treasuries, rose in value.
The more uncorrelated or even negatively correlated the assets are, the better the diversification strategy performs.
Uncompensated Risk and Diversification
Not all risk is created equal.
Uncompensated risk refers to the risk specific to a company, sector, or country.
For example, company-specifc risk basically means unexpected bad events for a specific company that cause it’s value to decline.
Specific stocks can and do underperform or even collapse due to a wide array of reasons, such as poor management, changing market dynamics, regulatory issues, or scandal.
For example:
- In 2000, Enron was a giant company valued at over $60 billion. It was revealed that it used accounting loopholes to hide its debt and inflate profits, leading the stock price to plummet and become worthless, as the company filed for bankrupcy in 2001.
A well-diversified portfolio brings uncompensated risk down to essentially zero.
This is because if you own a large variety of companies, some will have unexpected bad news, while others have unexpected good news, and so they cancel each other out, on average.
Despite this, it’s crucial to remember that diversification cannot eliminate all risk.
Market risk, the risk inherent to the entire market, will always be present, irrespective of how diversified your portfolio may be.
It is true that diversification decreases the probability of a large positive outcome. If you diversify, you are reducing the potential for exceptionally high returns because the stock you chose did exceptionally well. This may be an unattractive idea for some.
However, the primary objective of investing is to avoid significant negative outcomes. Remember the first rule of investing: don’t lose money.
Diversification Explain Why Stock Picking is Risky
Diversification is another reason why stock picking is not a good strategy.
- If you only choose a few stocks, you have a significant lack of diversification, and a lot of company-specific risk.
- If you choose many individual stocks, then you may have more diversification, but then your portfolio becomes complicated and time-consuming to manage.
This leads us to investment funds. These allow you to invest in hundreds or thousands of stocks just as easy as investing in a single stock.