Diversification Principles

Diversification is the only free lunch in investing. By spreading investments across different assets, you can reduce risk without necessarily reducing returns. [DEFINITION] Diversification: The practice of spreading investments across different securities, sectors, and asset classes to reduce the impact of any single investment's poor performance. ### Why Diversification Works [KEY] Different assets move differently at different times. When one zigs, another zags, smoothing overall portfolio returns. **Correlation:** - +1.0 = move together perfectly - 0 = no relationship - -1.0 = move opposite perfectly Combining assets with low or negative correlation reduces portfolio volatility. [EXAMPLE] Tech stocks and utility stocks often have low correlation. When tech falls (rate hikes), utilities might hold steady or rise (defensive sector). Owning both smooths returns. ### Levels of Diversification **1. Within Asset Class:** Own many stocks, not just one or two - 20-30 stocks provides most diversification benefit - Beyond 50, diminishing returns **2. Across Sectors:** Don't concentrate in one industry - Technology, Healthcare, Financials, Consumer, etc. - Each sector has different sensitivities **3. Across Asset Classes:** Stocks, bonds, real estate, commodities - Bonds often rise when stocks fall - Real assets hedge inflation **4. Geographic:** US, International, Emerging Markets - Different economic cycles - Currency diversification ### The Diversification Tradeoff [WARNING] Diversification reduces extreme outcomes—both bad AND good. A concentrated portfolio can outperform dramatically or underperform dramatically. **Concentrated (5 stocks):** - Higher potential returns - Higher potential losses - More volatile **Diversified (50+ stocks):** - More predictable returns - Lower extreme losses - Lower maximum gains ### Optimal Diversification **Too little (1-5 stocks):** Single stock can destroy portfolio. Company-specific risk dominates. **Optimal (20-30 stocks):** Most company-specific risk eliminated. Still can beat market. **Over-diversified (100+ stocks):** Basically an index fund. Hard to beat market. Might as well buy index fund for lower cost. [TIP] Warren Buffett is famously concentrated (10-15 positions = 70% of portfolio). But he has 60+ years of experience and billion-dollar resources. Most should diversify more. ### Correlation Mistakes Common "diversification" that isn't: - Owning 10 tech stocks (all same sector) - Owning Vanguard, Fidelity, Schwab S&P 500 funds (same underlying) - Owning Apple, Microsoft, Google, Amazon (all big tech, highly correlated) [EXAMPLE] During the 2022 tech crash, investors who thought they were diversified with FAANG stocks saw everything fall 30-60% together. These stocks are too correlated for true diversification. ### Rebalancing **Why rebalance:** Over time, winners grow larger than intended, losers shrink. Rebalancing maintains target allocation. **How to rebalance:** - Sell winners, buy losers (counterintuitive but effective) - Or direct new money to underweight positions - Quarterly or annually is sufficient [EXERCISE] Your portfolio target is 50% stocks, 50% bonds. After a year, stocks boomed and now you're 70% stocks, 30% bonds. How do you rebalance, and why is this emotionally difficult? |ANSWER| Sell stocks to get back to 50/50 (sell 20% worth and buy bonds). It's emotionally hard because you're selling what's been winning and buying what's been losing. But this is exactly the "buy low, sell high" discipline that most investors lack. [SCENARIO] You've built a diversified portfolio of 25 stocks across sectors. Then a stock you own gets acquired at a 40% premium, becoming 15% of your portfolio. Should you keep it? No, you should likely trim it back toward your target position size (perhaps 4-5%). Letting one position grow too large defeats the purpose of diversification. The acquisition price is now a new investment decision—is this company worth holding at the new price and weight? Usually, trim and reallocate.