Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. Evidence has shown that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, owning a portfolio specifically designed to take advantage of asset categories with dissimilar price movement, an investor can minimize volatility while continuing to pursue positive returns.

For example, let’s say there are two companies: one that sells umbrellas (Investment A) and a second that sells sunscreen (Investment B). One company performs well when it rains and the other preforms well when it’s sunny. If you were to have all your money in Umbrella’s (Investment A), sales would be high during rainy days and low during sunny days. The opposite would be true of the sunscreen sales (Investment B), good during sunny days and bad during rainy days. As you can see, Sunscreen and Umbrellas are negatively correlated. By investing equally in each of these companies, we have minimized the weather dependent risk associated with owning only one company. Through diversification, returns are decent no matter what the weather, rather than alternating between extremely good and terribly bad (see below).

The goal in diversification is to find several assets that are responding to different forces in the economy. If we have enough non-correlating assets in a portfolio, the odds of all of them falling into sync at any given point in time becomes very small. In fact, when one asset is taking a loss, there’s a good chance that one of the others will be making offsetting gains. Thus, a well-diversified portfolio of non-correlating assets can be quite stable despite the fact that various individual assets in the portfolio may be rising and falling dramatically in value.

A more realistic example of non-correlated assets would be Stocks and Bonds. That is why the majority of portfolios emphasize the proportion of equity’s vs fixed. In some cases, these asset classes have a negative correlation (5yr gov’t bonds vs Int’l Small Stocks (-0.213) which makes them excellent diversifiers.

Further diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. Global diversification across a variety of asset classes that behave differently is one of the most effective ways to reduce risk. Diversification is always working, whether we are pleased with the immediate results. There will always be one part of a portfolio that is going to perform better than the rest—-yet it’s impossible to predict which part it will be at any given point in time.

Invest internationally for diversification

• Over half of total market equity value is from non-U.S. stocks – companies listed on foreign stock exchanges number nearly 42,000 compared to roughly 6,500 in the U.S.
• It should come as no surprise that foreign stocks behave differently than U.S. stocks, making them an excellent source of broad portfolio diversification.
• A portfolio that includes both domestic and international equities has experienced higher returns and lower risks than a portfolio composed solely of either U.S. or international stocks (see chart).

Diversification is important because asset allocation has been proven to account for 91.5% of a portfolio’s performance. Diversification should be thought of as buying insurance against having all of your investment eggs in the wrong basket. More importantly, diversification is what keeps most investors in the game. You can’t grow your investments if you’re sitting in cash!

“Diversification is your buddy.”
-Merton Miller, Nobel Prize Laureate in Economics, 1990