Diversification is a word you’ll hear a lot as you read about various investment strategies, and though it sounds fancy it’s actually a pretty simple idea both to understand and to take advantage of.
It’s also the only way that you can decrease your investment risk without decreasing your expected return.
That makes it a pretty valuable tool. And in this post you’ll learn what diversification is, why it’s so powerful, and how to use it.
What Is Diversification?
Diversification is another one of those fancy-sounding investment terms that’s actually pretty simple when you break it down. All it means is spreading your money out over multiple different investments instead of putting all your eggs into one basket.
Rather than investing in a single company, you invest in many different companies. Rather than investing only in the U.S. stock market, you invest in international stock markets as well.
That is, instead of staking your investment fortune on a small subset of the opportunities available to you, you spread your money around so that some of it will always be in the best-performing investments.
And by doing so, you accomplish two things:
- You decrease your investment risk. The odds of you losing money are smaller when you diversify.
- You do so without decreasing your expected return. Your investments will be expected to perform just as well as if you didn’t diversify.
Diversification is quite literally the only way to accomplish those two goals at the same time. That’s why it’s the only free lunch in investing.
Why Diversification Works
There are a few main reasons why diversification works:
- Any individual investment, like the stock of a single company, comes with a lot of risk. The truth is that any single company could fail at any time for any reason.
- On the other hand, over the long-term the stock market as a whole has always proven to be a good investment. That is, while individual companies fail all the time, business at large has continued to succeed.
- Even professional investors aren’t very good at determining which individual investments will succeed and which will fail. Research actually shows that the vast majority of professionals underperform the market — which makes you wonder why they get paid so much money!
So by diversifying your investments and, say, investing in the entire stock market instead of a single company, you’re taking advantage of the long-term returns the stock market provides without the risk of any single company sinking your portfolio and losing you a lot of money.
Same expected return. Less risk that you won’t get it.
The Argument Against Diversification
The main argument against diversification is that you won’t strike it rich with the next Apple (AAPL) or the next Google (GOOG) when your money is spread out over many different investments.
Because while any single company can fail at any time, the reverse is also true. Any single company could turn out to be the next big thing, and if you’re heavily invested in it then you could make a lot of money in a short amount of time.
And it’s true: That won’t happen when your money is diversified.
Even Warren Buffett, the greatest investor any of us will ever see, agrees. According to Buffett, if you really want to dedicate yourself to the job of investing, you should limit yourself to your best six ideas and no more. Which is the exact opposite of diversification.
Of course, in that exact same talk, Buffett also says, “If you are not a professional investor… then I believe in extreme diversification. So I believe 98% or 99%, maybe more than 99%, of people who invest should extensively diversify.”
- Remember, the research shows that even professional investors aren’t good at picking the winners from the losers.
- The research also shows that individual investors consistently get much lower returns than the market as a whole, presumably because they are chasing home runs.
In other words, while it’s certainly possible to hit a home run when you put all your money into a single investment, it’s much more likely that you’ll strike out. It’s not a fun thing to admit, but it’s true.
And while diversifying may not be sexy and may not get you rich quick, it’s the strategy that’s most likely to be successful.
How to Diversify Your Investments
The key to diversification is using index funds.
Index funds are simply mutual funds that track a specific market. For example, there are index funds that track the U.S. stock market, the international stock markets, the U.S. bond market, and many more.
And index funds make diversification easy because they automatically spread your money out over many different investments, and they do so at a very low cost.
So the first step here is figuring out your asset allocation, which at a very basic level is simply deciding how much of your money to put into stocks and how much to put into bonds.
Then as you’re looking over your investment options, look for funds that fit your desired asset allocation and have “index fund” in the title.
For example, you might see something titled “Total Stock Market Index Fund”, which tracks the entire U.S. stock market. You might see similar funds for international stock markets and the U.S. bond market.
In some cases you may even be able to find a single mutual fund that handles all of those different types of investments for you. Vanguard’s Target Retirement and LifeStrategy funds are good examples. They automatically invest your money across both U.S. and international stock and bond markets, allowing you to be fully diversified across all types of companies all over the world with just a single investment.
In other words, diversifying can actually be pretty easy. With just one fund, or at most just a few, you can get all the benefits of diversification with minimal effort.
Quick note: Investing in a lot of different mutual funds is NOT the same as diversifying. A single fund that tracks the entire U.S. stock market is more diversified than several funds that hold similar investments and don’t combine to track the entire U.S. stock market.
The Only Free Lunch in Investing
Quite simply, diversification is the only free lunch in investing. It’s the only way to decrease your investment risk without decreasing your expected return.
And by spreading your money out across the entire investment landscape, you increase your odds of achieving the only investment objectives that really matter: your personal goals.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.