Why Should I Diversify My Investments?

While we all know there's "no such thing as a free lunch," diversification has been said to be the closest thing to a free lunch as we get in the world of investing. What diversification means here is not simply owning lots of different companies, but rather owning lots of different types of companies, to help avoid their values all moving up and down in step.

This means owning stocks like retail companies in America, finance companies in Europe, and manufacturing firms in Japan. These are different types of companies in entirely different markets, so if finance companies are struggling in Europe, it's not as likely for those Japanese manufacturers to be hurting as well. This allows you to capture growth in each of these totally different sectors while eliminating some of the risk because they're not all moving in sync.

When you own shares of companies in a bunch of different sectors, when some of them are up and others are down, your portfolio value falls in the middle. When that reverses and the mix of companies up and down changes, your portfolio still falls in the middle. Each of those companies is constantly fluctuating, but your portfolio as an average is more stable than the individual components.

Another real benefit of diversification is that it allows us to take advantage of what are called "dimensions of higher return," which are characteristics of companies that historically have indicated that these companies are more likely to outperform the market, as shown by academic research. For example, there was a study* done building portfolios that overemphasized companies with those characteristics, and this methodology was applied to various portfolios of 50, 200, 500, and 1000 US large companies. For the portfolios of 50 companies over a period of 10 years, they had a 69 percent chance of outperforming the market at large, which is considerably better than pure luck. However, for the portfolios diversified over 1,000 companies, over that same 10-year period they had a 96 percent chance of outperforming the market, which is a phenomenal success rate.

In essence, by having a much larger portfolio, it is much more likely that these dimensions we are trying to capture will have a positive effect. A great way to get this diversification is through pooled investments called mutual funds. We can then use these to build a portfolio that more consistently outperforms the market, all the while making portfolio returns less volatile as we mentioned before. It is the combination of these two benefits that show why you should diversify your investments.

*The aforementioned study refers to a paper written by Wei Dai, PhD, titled "How Diversification Impacts the Reliability of Outcomes," published November 2016.