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How Does Diversification Actually Work?

Diversification is a good thing. Nearly everyone agrees that it’s just about the only free lunch in finance.

But not many people stop and think about how diversification helps them, beyond the general “don’t put all your eggs in one basket” argument.

When you pull back the curtain, there’s actually a lot going on.

Diversification helps your portfolio in two big ways:

  • It reduces portfolio volatility
  • It allows you to focus on and capture specific risk factors.

Reducing Portfolio Volatility

The most commonly cited benefit of diversification is that it helps reduce your portfolio’s volatility. All of the different assets that you own don’t all move in sync with each other, so in a diversified portfolio, when one of your holdings is going down, another is likely to be going up, and they all tend to even each other out.

What’s interesting about this is that you don’t actually have to own that many things to get the majority of the volatility reduction diversification offers. As long as you have a decent sampling of the entire market, you get most of the benefit with fewer than 100 securities.

The companies you own need to be from different parts of the market – the less they look like each other the better. If you just own a bunch of big technology companies, you probably won’t get much volatility reduction because they will all act pretty similarly to each other.

Volatility reduction is really important – it’s a lot easier to live with and stay disciplined in a portfolio that’s relatively stable – but diversification’s other benefit is even more important.

Focus on Specific Risk Factors

Investment risk can be sliced up any number of ways, but one of the most useful is to look at systematic versus unsystematic risk.

Unsystematic risk is basically the risk tied to each individual company – it’s the risk that the CEO could get hit by a bus, or the company’s next product could be a complete flop.

The market doesn’t compensate you for this risk – it’s random noise against the backdrop of the entirety of the market. Sometimes the company will do better than expectations and it’s stock price will go up, and sometimes it will do worse and go down. Unsystematic risk can be diversified away because, if you’re doing it right, chances are that not every company in your portfolio will tank at the same time.

The other type of risk – systematic risk – is where you want to focus. This is the type of risk the market pays you for taking, and it comes from putting your money to work.

It also goes by another name: non-diversifiable risk (investment folks aren’t great at naming things). In other words, it’s the risk that is left over after you get rid of all the company-specific risk through diversification.

This is crucial because this is what allows you to effectively design your portfolio. Zeroing in on systematic risks lets you build your portfolio to take the amount and type of risk you are comfortable with.

Most people (and pretty much the entire financial media) spend their time thinking about the stuff that the markets don’t pay you for. But choosing between Facebook or Apple won’t change your portfolio’s expected return over time. What actually drives your long-term performance is how you position your portfolio in terms of systematic risk.

If you can focus your portfolio on risks the market actually pays you to take in the long term, you’ll be able to harvest those market returns and keep moving toward the retirement you want.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

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