Why Is Diversification Important In Investing? (Benefits And Advantages)
Harry Markowitz won the Nobel Prize in 1990 for his work in showing mathematically how you can both reduce risk and create better returns by diversifying across regions and assets. Risk is of course measured in volatility, ie. how your assets fluctuate in price. Such a theory was new when it was first released in the 1950s, and Markowitz said it’s the closest thing you get to a free lunch.
This article discusses why diversification is important in investing, and in the end, I write how I have allocated my capital between several different asset classes.
We can question how valuable volatility is for measuring risk, but to me it makes sense because of the behavioral mistakes that follow big moves on the downside. When we are fearful we tend to do irrational things. Furthermore, research shows retail investors underperform the market substantially and two of the reasons are overconfidence and lack of diversification.
Systematic and unsystematic risk (diversification matters)
The risk in the stock market is divided into two parts: systematic and unsystematic risk.
Systematic risk refers to the risk in the entire market. For example, the sum of all stocks go either up or down, which is impossible to diversify, and that is called systematic risk. This is a risk you can’t avoid.
Opposite, we have unsystematic risk that refers to a specific company or industry. Example: If you buy all the stocks in the S&P 500 adjusted to market capitalization, you have diversified all unsystematic risk for that asset and only have systematic risk which you can’t control. Opposite, if you only buy Foot Locker you are obviously dependent on the performance of that stock. This means you put on huge unsystematic risk.
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But the beauty of diversification is that you can invest in other assets besides stocks: real estate, gold, bitcoin, bonds, hedge funds etc. In that way, you have returns that are not correlated (hopefully). This means for example stocks might go down, but your assets in gold and bonds might in the same period go up.
Back to stocks: The graph below shows how many stocks you need to own in order to limit unsystematic risk (based on simulations on the Oslo Stock Exchange). Already with 10 stocks, you have reduced unsystematic risk substantially and the marginal utility to include more stocks is pretty low. This means that you only need 8-15 stocks on the Oslo Stock Exchange to limit most of the unsystematic risk.
Women are better investors than men because they diversify
Research shows women are better investors than men. Why is that? The main reason is that men take on more unsystematic risk in their portfolios. Pareto Securities wrote a blog post (in Norwegian) about diversification and how retail investors gravitate toward few and inherently risky stocks. In their unofficial survey, only 25% of the retail investors owned more than 7 stocks! The combination of few and riskier stocks usually doesn’t end well.
Some words about Warren Buffett and diversification
Warren Buffett is not an advocate of diversification. He claims volatility is a poor measurement for risk, and diversification usually leads to “diworsification”.
It makes sense because you only need a very few good investments to compound and become wealthy. But what are the chances that the average retail investor will find such businesses and at the same time have the faith and patience to hold it for many years or decades? I would say this is pretty unlikely unless you both know yourself very well and at the same time has a good business sense.
Because of this, Buffett recommends the average investor to invest passively in the S&P 500. The slow and steady method of dollar-cost averaging is the best method for 99% of retail investors.
Unfortunately, overconfidence leads many investors liable to unsystematic risk that they are most likely not able to benefit from.
We have to keep this in mind:
- Warren Buffett is very smart.
- Warren Buffett is very rational, not prone to behavioral mistakes/cognitive errors.
- Warren Buffett has a lot of time to study investments.
- Warren Buffett has investment opportunities the average investor doesn’t have.
- Warren Buffett has the confidence to concentrate his holdings.
In my opinion, you need all these attributes to be an active investor. Needless to say, this excludes, in my opinion, 99% of potential investors.
The most important thing is to avoid ruin – thus diversify
The potential cost of not diversifying is a potential loss of capital and subsequent difficulties to recover. The more you lose, the more return you need to recover the losses:
The chart above explains pretty well why you should always aim to preserve your capital.
For example, if you lose 80% of your capital (shown on the x-axis as 20% of your capital remaining), you need a 400% return to get back to break even. Obviously, that is not an easy task.
How should you diversify?
Obviously, there is no exact method of diversifying as it depends on your goals and amount of capital. Simply buying a few mutual stock funds works very well for most people, especially if you have a monthly savings plan. Dollar-cost averaging beats most “experts”.
Below I have summarized how I have spread my assets for diversification. My aim is to protect my capital for retirement adjusted for inflation, not necessarily to have the best returns:
- 3% is in gold.
- 15% is spread among 9 market-neutral hedge funds.
- 14% in cash (too much, I know).
- 5% is my place of residence (real estate).
- 15% in mutual funds (stocks).
- 33% directly in stocks (too much).
- 1% in p2p loans/crowdfunding.
- 14% in rental real estate.
My logic is as follows:
Gold: My biggest fear is always inflation. We’ve had 40 years of minimal inflation, and inflation is “forgotten”. But I have a distrust against central bankers and planners, and owning gold is simply a tail-risk hedge against a new potential Weimar experience. Furthermore, gold is often uncorrelated to the stock market.
Hedge funds: I have them to offset any long-term bear markets in the stock market. Over the last decade, these funds have underperformed the stock market, but in 2008 they managed a positive 8% return while the stock market crashed. So far during Covid-19, they have outperformed again. I expect a return similar to the inflation rate plus an additional tiny risk premium.
Cash: I know it contradicts my fear for any resurgence of Weimar-inflation, but I need cash in case the stock market suddenly drops or any interesting investment opportunity comes along. I like having several years of cash to cover my living expenses. Disclosure: I’m quite frugal and live a pretty minimalistic life.
Residence: I like to own my own residence, and have an apartment in the city center.
Direct stocks: I own too many stocks (spread among three brokers), both in numbers and amount, and the allocation is too big compared to my mutual funds. I’m looking to allocate more to mutual funds and less to stocks.
Mutual funds: In case my stock picks go bad, I like to have mutual funds. I consider my mutual funds my core retirement plan. This is “buy and forget/hold”.
P2P/crowdfunding: I dipped my toe in many platforms but concluded this an investment with a lot of hidden risks. I wrote about my experience in this article.
Real estate: To hedge against inflation I own some real estate that I rent out and manage myself. Sometimes it’s a hassle, but it produces some monthly income that is my main source to pay for milk, bread, and butter.
I believe the best thing to do is to invest passively in mutual funds, both for stocks and real estate. Only when you have built a “buffer” of passive investments should you go out on your own.
Most retail investors are better off by focus their efforts on how to generate income via a regular job and simply save monthly via mutual funds. Don’t try to be smart, and make sure you are well inside your circle of competence before you do anything.
Disclaimer: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.