Become a better investor
Lesson in Course: Portfolio management (beginner, 5min )
Investing requires taking some risk. Here is a way to reduce the amount of risk.
Diversification is the process of reducing the risk of a portfolio by investing in a variety of assets. We can remember this using the adage, “don’t put all of your eggs in one basket.”
By investing in various assets, we reduce the exposure to any one particular asset or risk. This way, if anything bad happens to one asset, we don’t lose all of our money, or if something happened to one basket, we don’t lose all of our eggs.
We can diversify on an asset class level by investing in stocks and bonds and within the asset class, such as buying stock in Tesla and Walmart.
Diversification works because of the correlations between assets. By investing in various assets, we can expect to see the value of some go up while others go down.
This means that losses of some assets are offset by gains of others which reduces how much the total portfolio fluctuates. These fluctuations are what we use to measure risk, so we reduce the risk of our portfolio by reducing these fluctuations.
Diversification has a greater effect when there is less correlation between the assets.
For instance, investing in Apple stock and Microsoft stock will still reduce some risk but much less than if we created a portfolio invested in Apple stock, Treasury bonds, and gold because there is a greater correlation between Apple and Microsoft than Apple, Treasury bonds, and gold.
Not only are Apple stock and Microsoft stock both the same type of asset, but both companies have similar product offerings and risks. In contrast, bonds and gold are different asset classes that have different associated risks. The greater these differences are, the more diversification.
The graph below shows the growth of three portfolios over five years, from April 2, 2015, to April 2, 2020.
Portfolio 1 and 2 look very similar, and that’s because AAPL and MSFT have a fairly strong correlation. However, there is a very slight diversification benefit that is barely noticeable.
On the other hand, we can see how combining assets with low correlations reduces risk by looking at Portfolio 3. There are significantly smaller fluctuations in the portfolio value over time which means this portfolio has significantly less risk than the others.
Use this free tool to play around with different portfolios to see how you can minimize the risk while trying to maximize the return:
Diversification is an easy way to reduce the risk of a portfolio. Add more varying types of investments to your portfolio to continue to reduce risk; however, keep in mind that this eventually leads to a trade-off between risk and return. At some point, you’ll be giving up potential returns for less risk.