Does portfolio diversification work?
Diversification can help investors mitigate losses during periods of stock market and economic uncertainty. Different asset classes and types of investments perform differently at different times and are based on different impacts of certain market conditions. This can help minimize overall portfolio losses.
Correlation and risk mitigation
At the heart of portfolio diversification is the view that owning diverse investments will help limit one's exposure to any single asset class or its concentrated risk profile, yielding more stable long-term returns and lowering the risk by dampening the portfolio's volatility.
Investment portfolios that obtain the highest returns for investors are not usually widely diversified. Those with investments concentrated in a few companies or industries are better at building vast wealth.
Just because one asset class is doing well or poorly at any given time doesn't mean you should include or exclude that asset class from your portfolio. A diversified portfolio might outperform or underperform an index such as the S&P 500, which only measures U.S. large cap stocks, on any given day, quarter or year.
Diversification can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of stomach-churning ups and downs. Remember, diversification does not ensure a profit or guarantee against loss.
Over diversifying your portfolio reduces the magnitude of gains you could have from the good funds in your portfolio (since to invest in many funds, you'll be investing less in each fund). To put it another way, with wide diversification, you will not lose much, but you do not stand to gain much, either.
As a general rule of thumb, most investors would peg a sufficiently diversified portfolio as one that holds 20 to 30 investments across various stock market sectors. However, others favor keeping a larger number of stocks, especially if they're riskier growth stocks.
Financial-industry experts also agree that over-diversification—buying more and more mutual funds, index funds, or exchange-traded funds—can amplify risk, stunt returns, and increase transaction costs and taxes.
A diversified portfolio should have a broad mix of investments. For years, many financial advisors recommended building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds. Meanwhile, others have argued for more stock exposure, especially for younger investors.
Diversified management investment companies have assets that fall within the 75-5-10 rule. A 75-5-10 diversified management investment company will have 75% of its assets in other issuers and cash, no more than 5% of assets in any one company, and no more than 10% ownership of any company's outstanding voting stock.
What if I invested $1000 in S&P 500 10 years ago?
A $1000 investment made in November 2013 would be worth $5,574.88, or a gain of 457.49%, as of November 16, 2023, according to our calculations. This return excludes dividends but includes price appreciation. Compare this to the S&P 500's rally of 150.41% and gold's return of 46.17% over the same time frame.
S&P 500 5 Year Return is at 83.02%, compared to 79.20% last month and 46.29% last year. This is higher than the long term average of 45.06%. The S&P 500 5 Year Return is the investment return received for a 5 year period, excluding dividends, when holding the S&P 500 index.
One of the main reasons is that some investors believe they can outperform the market by actively selecting individual stocks or actively managed funds. While this is possible, it is not easy, and many studies have shown that the majority of active investors fail to beat the market consistently over the long term.
Does portfolio diversification eliminate investment risk? While diversifying your portfolio can help reduce investment risk, diversification does not eliminate it. Stocks, bonds, and other investments still carry the risk of losing money in certain market and economic conditions.
Systematic risk, also known as market risk, cannot be reduced by diversification within the stock market. Sources of systematic risk include: inflation, interest rates, war, recessions, currency changes, market crashes and downturns plus recessions.
Market risk, also called systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways and tends to influence the entire market at the same time. Specific risk, in contrast, is unique to a specific company or industry.
A company's competitive advantage will be short-lived, and diversification will fail, if competitors in the new industry can imitate the company's moves quickly and the company's moves quickly and cheaply, purchase the necessary strategic assets in the open market, or find an effective substitute for them.
Investors are warned to diversify their portfolios, meaning that they should never put all their eggs (investments) in one basket (security or market). To achieve a diversified portfolio, look for asset classes with low or negative correlations so that if one moves down, the other tends to counteract it.
“One of the main reasons that diversification fails is because businesses do not have the right strategy in place,” Shipilov said. “They must think carefully about what distinct resources or capabilities they can move between different markets to give them a competitive advantage.
Generally speaking, fewer than 10 ETFs are likely enough to diversify your portfolio, but this will vary depending on your financial goals, ranging from retirement savings to income generation.
Is it better to invest in one ETF or multiple?
Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.
A $100K windfall can help you secure your financial future, but not everyone is comfortable deciding what to do with that much money. If you don't have the time, interest, experience, or confidence to build a diversified investment portfolio, a robo-advisor or financial advisor can help.
Diversification is a key principle of portfolio management. It is the practice of not putting all of your portfolio's eggs in one basket. And its importance can often be forgotten due to specific biases we all can fall victim to.
A good diversification strategy can help investors reduce the risk of owning individual stocks, but it is possible to have too much of a good thing. Over-diversification can end up reducing a portfolio's returns without meaningfully reducing its risk.
When you diversify your investments, you reduce the amount of risk you're exposed to in order to maximize your returns. Although there are certain risks you can't avoid, such as systematic risks, you can hedge against unsystematic risks like business or financial risks.
