The Portfolio Diversification Fallacy

One of the most widely recognized investing principles is portfolio diversification. Surprisingly, novice and seasoned investors alike often misinterpret the true meaning of diversification. A common misconception is that diversification means no more than investing in many different companies. Subscribers to this fallacy may fill their portfolio with high profile glamour stocks, for example, that appear in the headlines day after day. Akin to a collection of unrelated shiny objects, these investments typically offer few of the benefits of diversification. A well-diversified portfolio bears little resemblance to a random collection of shiny objects.

A well-diversified portfolio maximizes rate-of-return while minimizing risk. While no portfolio can diversify away 100% of investment risk (more details on that another time), a diversified portfolio, on average, generates higher returns at a lower risk than an undiversified portfolio. This is achieved by investing in an array of different investment types, not a large number of the same investment type.

For example, a portfolio of 20 different bank stocks may seem diversified. But if interest rates go down, the banking industry will be negatively impacted and the entire portfolio could decline all at once. This is because bank stocks are similar to each other and, as a result, have a strong positive correlation. If, however, a portion of the portfolio was invested in telecommunications stocks, only a portion of the portfolio would be affected by the decline in bank stocks. The telecom stocks may even rise in value as interest rates fall. In this example, bank stocks and telecom stocks are negatively correlated.

A good portfolio manager skillfully combines positively and negatively correlated investments within a portfolio to maximize rate-of-return at the lowest possible risk. Accordingly, he/she will not expect every holding in the portfolio to go up or down in price at the same time. The result is a smoothing out of price swings in order to achieve more consistent positive returns.

The easiest way to diversify a stock portfolio is to purchase some bonds. Bonds are negatively correlated with stocks. In a stock market correction, or a bear market, bonds will neutralize some of the negative performance of stocks and vice versa. In this way, proper diversification will mitigate substantial risk and, on average, enhance portfolio rate-of-return. The “on average” provision is an important distinction because diversification is not a guarantee against loss. Portfolio volatility will still occur in a well-diversified portfolio albeit within a narrower band. Over time this will capture much of the market’s return while avoiding deep market pullbacks.