Does Diversification Actually Reduce Risk?

how does diversification reduce risk

By Thomas Kenny. Bonds Expert

A common misperception among individual investors is that diversification helps eliminate risk. In fact, this isn’t necessarily true – while diversification can help reduce risk. its effectiveness in doing so depends largely on the way you diversify.

What Diversification Does, and Does Not, Accomplish

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First, let’s take a look at what diversification doesn’t do:

1) Diversification won’t improve your returns. Diversification isn’t a way to make more money. It certainly won’t make you rich, and there’s no guarantee that it will provide a better return than a non-diversified portfolio.

2) It doesn’t eliminate risk. There is so much discussion in financial literature about the ways diversification can reduce risk that many novice investors make the leap to assuming that it eliminates risk altogether.

This isn’t the case – if you own investments whose principal can decline in value, you’re taking on the risk of loss no matter how well-diversified the portfolio.

Instead, the goal of diversification is to reduce the risks associated with “putting all of your eggs in one basket.” The idea is that not all asset classes move in the same direction, with the same magnitude, at the same time. In this way, investors can – but aren’t guaranteed to - experience a smoother ride in terms of the volatility of their overall portfolio.

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A classic example is the combination of stocks and U.S. Treasuries. While it doesn’t always work this cleanly in real life, stocks typically respond well to an environment of improving economic growth, while Treasury bonds do not. Conversely, slower economic conditions typically lead to stronger performance for government bonds (find out why here ), but it can be less favorable for stocks. By combining the two asset classes, the investor ideally creates an all-weather portfolio where one asset should be in a position to perform well under all economic conditions. The investor may not earn as high of a total return from the combined portfolio by being invested entirely in stocks, but he or she would also have had the benefit of lower day-to-day volatility.

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Quality, not Quantity: It’s the Way You Diversify that Counts

In order to gain the full benefit of diversification, investors need to make sure that their portfolios are

diversified by the type, rather than the number, of investments.

Unfortunately, many individuals take the approach that “more is better” when it comes to diversification. In other words, the more funds you own, the more effectively you have diversified your portfolio. In reality, that isn’t the case at all. Consider an investor who purchases six U.S. stock funds, but with four that focus on large companies. Even if there are slight differences among the various funds, there is probably a high degree of overlap in the individual holdings. More important, all of those funds will exhibit very similar performance characteristics – meaning that when the market goes down, all of these funds are likely to fall by the same amount.

As a result, it’s essential to choose investments that provide actual diversification and not just the illusion. When buying a new fund, an investor should ask his or herself:

  • How does the fund compare to my existing holdings? Is it meaningfully different, or does it overlap?
  • Even if the category is different – say, adding high yield bonds to a stock-heavy portfolio – does it have different performance characteristics? (In this case, the answer is actually “no” – high yield bonds tend to track the stock market very closely over time.
  • Is the new investment appropriate for my objectives and risk tolerance. or will diversifying potentially increase risk? (For instance, adding emerging market bonds to an otherwise conservative portfolio improves diversification but it also increases risk.)
  • Am I a “fund collector?” Some people simply like to buy new funds that they hear about, whether they need the funds or not. This isn’t necessarily a bad thing, but it does exhibit a lack of discipline – and it adds to paperwork and tax headaches .

The Bottom Line

Don’t make assumptions about diversification – while you think you may diversified, that might not be the case in reality. Always take a closer look to make sure your investments are meeting your objectives as intended.

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Disclaimer. The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.

Source: bonds.about.com

Category: Insurance

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