What is Diversification?
One of the greatest benefits of a portfolio management strategy is being able to heavily use diversification.
Intuitively, diversification refers to "don't put all your eggs in one basket." If something bad happens that has a negative effect on one of your investments, holding other investments that are very dissimilar make it is less likely to also negatively affect those investments.
Better Risk - Return Tradeoffs
Professional investors are evaluated by their ability to balance risk and return. These investors are constantly looking for the investment that can generate the highest return for the lowest risk.
Portfolio Theorists have mathematically proven that investors can achieve better risk/return ratios when combining more than one investment together. Generally, they saw that the more dissimilar the combined investments were, the greater the boost in their combined risk/return profile.
Combining a set of investments that are dissimilar is known as a Diversification strategy.
Diversification is most associated with decreasing the risk of a portfolio. Theorists show that with diversification investors can achieve the same expected return, but by taking less risk, making these strategies superior to their non-diversified counterparts.
Intuitively it is simple, the more bets that you make the higher likelihood of you hitting winners, which can balance out the losers that you choose.
Is there a limit to diversification?
Imagine investing in every single investment available in the world. Would this be a good strategy? While this sounds extreme, there are many professional investors who try to do this. Professionals like Ray Dalio fully endorse diversification and hold thousands of investments in their portfolios.
Other professionals like Charlie Munger (Warren Buffet's partner) preach: "True professionals should be able to choose the best investments, being too diversified is a sign of being unskilled."
Regardless of where you land on the spectrum of diversification, most professionals agree that diversifying to some degree is wise. Finding the right balance of diversification and investment picking will be critical to your success. At EquitySim, we believe that if you are less skilled, leaning towards high diversification makes the most sense.
How can I improve my diversification?
Use our diversification score to guide you towards higher diversification. While there are many ways to slice investments in terms of similarity the elements we focus on at EquitySim are: Asset-Class Type, Country, and Industry.