The concept of Diversification is relatively straightforward – it involves spreading your money across different kinds of investments (or asset classes) to balance out the highs and lows in the market. This all sounds great, but how do you decide between the multitude of investments that are available to you to hold?
Unfortunately, there is no simple or ‘one size fits all’ solution out there. Your stock portfolio can include a few securities or many, and this is a decision you should make in consultation with your financial advisor or based on your own research and judgment.
Generally, the decision will depend on how closely your asset classes, and investments within each subclass, track one another’s returns—a concept known as correlation. For example, if Stock A always goes up and down as much as Stock B, they are said to be perfectly correlated. In contrast if Stock A always goes up the same amount that Stock B goes down, they are negatively correlated. In the real world, securities often vary in the degree to which they are positively correlated with one another. Ideally, you want to aim for less positively correlated investments in your portfolio to smooth out the bumps in the market in order to make yourself less susceptible to fluctuations in the market.
Many investors turn to pooled investments like stock and bond funds in an attempt to build a diversified portfolio of which mutual funds and exchange-traded funds are the most popular and cost-effective choices. Pooled investments typically include more varied underlying investments than you are likely to assemble on your own, which makes them suitable for mitigating your risk. However, you need to be certain that even the pooled investments you own are diversified or you have completely defeated the purpose of holding pooled investments to begin with.
We believe that in order to build a well-diversified portfolio you must have exposure to all of the various markets and take a more global approach. We generally recommend holding around 12,000 stocks in over 44 different countries which will allow your portfolio to benefit from all the opportunities that the global markets offer. The graphs below provide a simple example of how a diversified portfolio helps smooth out the highs and lows (volatility) of investing in individual stocks. The more stocks you add to your portfolio, the smoother the ride becomes. You may also want to add some short-term bonds to diversify your portfolio, depending on your risk tolerance, to reduce highs and lows even further.
We believe that concentrating your portfolio in any one country or asset class unnecessarily exposes you to large variations in returns. A simple way to think about diversifying your portfolio is your ability to capture returns while minimizing risk. If the international markets are doing very well compared to the US markets, but you lack international holdings, then you just missed out on an opportunity to capture those returns. By diversifying your investment portfolio, you minimize your potential risk by spreading out your investments but also allow yourself to benefit from a more consistent outcome – decades of research prove that betting on the global markets will give you the smoothest ride.