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Diversification: The "Free Lunch" of Portfolio Building

Diversification is the basic strategy of trying to limit exposure to risk by investing in an uncorrelated mix of assets. That might be a mouthful, but it just means owning investments that respond differently to different market pressures. It is the “don’t put all of your eggs in one basket” of the investing world.

It’s also known as “the only free lunch in investing” because, when done properly, diversification has the potential to reduce your overall risk while sacrificing little – if any – long-term return.

Different investments face different threats: Stocks face bankruptcy risk, bonds face interest rate risk, agricultural commodities face weather risk, and so on. Any one of those risks can sink an overly concentrated portfolio. But by spreading your portfolio over many unrelated assets and asset classes, you limit the damage any one risk can do.

The quilt chart below brilliantly visualizes this dynamic. Year-in and year-out, different asset classes and investment styles shine as the market reacts to ever-changing conditions. As you can see, there have been no consistent winners – the top asset class in 2018, Cash and Cash Equivalents, was the worst-performing asset class in 2019. The fact of the matter is, the financial market’s tendency to revert to the mean often turns last year’s winners into next year’s losers.

Rolling Asset Class Returns, 2010–2019

Diversification Chart
Source: Morningstar Direct; Standard & Poor’s. As of December 31, 2019. Annualized return, volatility (as measured by standard deviation) and Risk-Adj. Return (as measured by Sharpe ratio) are calculated as of the most recent quarter-end. Large Growth is represented by Russell 1000® Growth Index. Large Value is represented by Russell 1000® Value Index. Mid Cap is represented by Russell Midcap® Index. Small Cap is represented by Russell 2000® Index. Taxable bonds is represented by BBgBarc Intermediate Govt/Credit Bond Index. Municipal bonds is represented by the BBgBarc Municipal Index. International is represented by The MSCI EAFE Index. Cash is represented by FTSE 3 month T-bills. Satellite is an equally weighted return of the following indices, rebalanced monthly: ICE BofAML US High Yield (High Yield), DJ US Select REIT (Real Estate), Bloomberg Commodity (Commodities), and MSCI Emerging Markets (Emerging Markets). Indices are unmanaged and are used to measure and report performance of various sectors of the market. Past performance is no guarantee of future results and diversification does not ensure against loss. Direct investment in indices is not available. The Russell Indices are a trademark of the Frank Russell Company. Russell® is a trademark of the Frank Russell Company.

This pattern holds across every investable asset you could imagine. Industrial metals, emerging market countries, agricultural commodities – you name it. Diversification is a universal concept rooted in math, and it is central to building robust, resilient portfolios. While it does not guarantee against loss, it is one of the best tools in an investor’s toolkit to succeed over the long term.

The world is full of uncertainties and risks – investment-specific, country-specific, asset class-specific, etc. We cannot escape these uncertainties nor can we predict the future, but through proper diversification (and, crucially, regular rebalancing), we can spread out our exposure and limit the damage done by any single risk at any given time.