Investopedia defines diversification as “a risk management strategy that mixes a wide variety of investments within a portfolio” (3). This is not a new idea; it was first mentioned in an economic sense by Bernoulli in a 1738 article (1) where he argued that risk-averse investors would want to diversify: “Another rule which may prove useful can be derived from our theory. This is the rule that it is advisable to divide goods which are exposed to some danger into several portions rather than to risk them all together.” The Nobel Laureate Harry Markowitz pioneered modern portfolio theory in his 1952 paper “Portfolio Selection” that implemented diversification in several security types to maximize expected returns given the investors risk tolerance (2). Some examples of these securities are U.S. and Foreign Stocks, U.S. and Foreign Fixed Incomes (Bonds or Money Market Funds), and Commodities. This diversification strategy has been very popular with pension funds and retirement accounts because it is passive in nature.
Upon a more in-depth examination of this diversification strategy, we begin to see some inconsistencies in the reasoning that spreading out your investments will protect from downside risk. The S&P 500 has had six significant equity losses of 30% or below since 1956. During these down periods, the market as a whole was down, so even if your portfolio was spread among many sectors, in all, you were generally affected the same. The hope is that the fixed income instruments in the portfolio can be implemented to mitigate any equity losses. Unfortunately, it is difficult for fixed income instruments to cancel out any equity losses due to inflation and low yields. Ultimately, this major downfall leaves this strategy not efficient in protecting from downside risk.
Diversification can also mitigate portfolio performance. There are a time and place for equities, fixed income instruments, and commodities, but it is rarely best to deploy into all of these securities simultaneously. If one security type is better than another, then utilizing that opportunity with the best return on investment is the best use of capital. Warren Buffett, the most renowned investor of all time, stated that “diversification is protection against ignorance. It makes little sense if you know what you are doing.” Diversification is “protection” for passive investors (3). So, is it beneficial to be an active or passive investor?
- Bernoulli, D. (1954). EXPOSITION OF A NEW THEORY ON THE MEASUREMENT OF RISK. Econometrica (pre-1986), 22(1), 23-36.
- Chen, James. “Modern Portfolio Theory (MPT).” Investopedia, Investopedia, 16 Mar. 2020, www.investopedia.com/terms/m/modernportfoliotheory.asp.
- Pike, Richard et al. (2018) Corporate Finance and Investment: Decisions and Strategies, â€œChapter 8: Relationships between Investments: Portfolio Theoryâ€, Pearson, 2018.
- Segal, Troy. “Diversification.” Investopedia, Investopedia, 9 Mar. 2020, www.investopedia.com/terms/d/diversification.asp.