How diversification works

There are a few sayings in Finance that impart basic yet fundamental wisdom onto investors. There's of course the buy low sell high motto and for more Buffett, the famous "be fearful when others are greedy and greedy when others are fearful". But there's one saying that doesn't get as much love from first-time investors. "don't put all your eggs in one basket". The idea here of course is that putting your life savings into one position is risky. If that one company happens to falter your best egg might not survive the fall. 

But in today's world of flashy IPOs and budding industries literally, in some cases some beginners like the idea of doubling down with one or two holdings and on the other side of things, some investors believe it's possible to dilute your returns if you over diversify. so what's the middle ground here? and how does diversification actually affect our portfolios? we'll answer these questions and more. 

Diversification is a risk management strategy, that involves holding your money across an array of different investments. So as to reduce your exposure to what are known as idiosyncratic risks. These risks also known as business or company specific, are the unique risks that a company faces. They can include anything from management, making a bad investment on a new product launch to new regulation cutting the sales of a company, even a natural disaster blowing up a key facility. Any corporation can succumb to some idiosyncratic risk. so by only holding a fraction of your money in each position, you help ensure that a negative event at one company doesn't lead you to lose your shirt. In this way diversification reduces the risk of our portfolio.

 This can be easily demonstrated with an example: Imagine you have two investors one with $100,000 invested in one stock and the other with 100,000 split across 10 different stocks. So $10,000 in each stock has a two in three chance of doubling its money, but a one in three chance of losing everything. Obviously we would expect both investors to earn a positive return given the higher odds, but the diversified investor is taking noticeably less risk. After all the first investor has a one in three chance of losing everything. A pretty significant risk. whereas the second investor would only lose everything if every investment happened to hit it's 1 in 3 odds. An incredibly unlikely outcome. More often than not the majority of investments will earn a positive return. And while few positions may lose everything the positive performance of other stocks will likely offset these negative returns.

 So by splitting out our holdings we reduce our risk. But diversification doesn't just mean holding a bunch of different stocks. It works best when positions in your portfolio are uncorrelated. Meaning that their correlation coefficient is close to zero. All this means is, that the stock prices need to move at least somewhat independently of one another. Something that makes sense when you really think about it. After all, if in our example our stocks in the diversified account had a 95 percent chance of all showing the same result, we end up facing a very similar risk profile to the first investor. 

If you're interested in actually calculating the correlation of different investments, there's a tool on portfoliovisualizer.com that does the math for you. But for those less interested in the numbers, a common approach for ensuring your positions aren't perfectly correlated is to invest across different industries and sectors. Companies in each sector face unique risk profiles. For example, banks benefit from the rising interest rates, since it allows them to charge more for their loans. Well real estate companies benefit from falling interest rates as it allows them to borrow more money to buy more buildings. Holding investments in both therefore reduces the risk of your portfolio taking hit from interest rate changes one way or the other. 

Investors may also diversify by investing in companies of different sizes. And it's common to invest in different countries, since this reduces the risk of geopolitical factors like tariffs and war affecting your results. Now globalization has limited the impact geographic diversification has had unprotected stocks from risks. And all stocks maintains some degree of correlation especially during downturns. So it's common to also split money between asset classes. With investors holding cash equivalents, stocks, fixed income and alternatives to reduce the asset specific risks of their holdings. All of this is thought to benefit the risk return trade-off of a portfolio.

 According to modern portfolio theory or MPT a popular approach for building investment. Portfolios investing in uncorrelated assets increases the amount of return we get per unit of risk that we take. On making our investments more risk efficient now modern portfolio theory assumes that risk is equal to a stock prices volatility or how much it fluctuates which is a rough assumption. But one of the observed benefits of diversification is that it smooths out the price volatility of your entire portfolio.

 If we go back to our example, we can compare fluctuations in our investors portfolios, to visualize this effect. If we repeat our probability event for the two investors and graph the outcomes to show portfolio growth over time, all while ignoring compounding for simplicity, it might look something like this.

Clearly the diversified portfolio offers smoother performance. Providing them much easier ride to stomach whereas the first portfolio, well not so much. So you can see why diversification is considered such a fundamental component of investing. It reduces the probability of experiencing severe declines in our portfolio, limiting leti. given this, it might seem like a no-brainer to go out and cram as many stocks as you can into your account, but according to MPT stocks have a shrinking marginal diversification benefit. That is every additional stock you add to your portfolio decreases volatility by smaller and smaller amounts. If you graph it this relationship might look something like this.

The first few positions have a dramatic effect on volatility, but as you reach 20 stocks or so the benefit plateaus. You'll also see that diversification doesn't remove all volatility from the account. Namely, it leaves behind what's known as systemic or market risk. Risks that affect a wide range of companies. we of course, cannot remove all risk from our portfolio when we invest. so this is to be expected. But even with a portfolio of say 30 stocks you can see that you've already captured most of the benefit diversification offers. 

Now for someone starting off, clearly stocks can be a difficult threshold to hit if you've only got a few thousand dollars to invest. You'll find yourself paying a high percentage in transaction fees to maintain a 30 stock portfolio. Not to mention that with some stocks like Google, trading at prices above $1,000. They'll be difficult to evenly split your money across different positions. Luckily innovations in the field have made it incredibly easy to diversify your holdings.

 We started to see zero fee broker services in products like mutual funds and exchange-traded funds allow investors to gain exposure to hundreds even thousands of stocks through just one unit. But if the marginal benefit of diversification becomes negligible after say 30 stocks, is there a point to holding thousands of positions? could it actually be harmful to invest in that many companies? well that depends on who you ask.

 For passive investors diversifying across thousands of stocks is the ideal approach, since it removes virtually all companies specific risk. But for active investors there's a downside to having too many positions. For one there's the cost if you're investing outside of an ETF. Holding more stocks means there are more positions to trade. And if you are regularly rebalancing your portfolio, this can lead to pretty hefty transaction fees. There's also the fact that staying on top of all these companies will be more time consuming. And holding too many positions will reduce the marginal benefit of your analysis per each company. If you identify a stock you believe to be undervalued, decide to add it to your account, it won't have much of an impact if it's just one of a thousand positions.

 You hold to earn above average returns, you might have to find a hundred stocks that you think are going to do exceptionally well. At all tasks for anyone. This is one criticism faced by large mutual funds which often have rules preventing them from holding too much money in individual companies. This means that as funds grow in size so too, do the number of positions they invest in. Making it harder and harder for them to deliver the Alpha returns that they promised to investors for their fees. So some active investors are critical of taking diversification so far as to investing companies that they don't know like or understand more.

 Buffett for example is a fan of the big swing analogy. Waiting for the right pitch and then taking a big position. That being said no one would disagree that putting all your money in just a few stocks is probably a bad idea. So while the degree of diversification is a topic of debate, having some diversity is a prudent portfolio practice. So try to ensure you don't have all your money tied up in just a few investments or sectors. And if you're just starting off consider using funds until you have enough money to build a complete portfolio with individual securities. Assuming you want to make that switch also make sure to avoid false diversification. whereby you purchase multiple mutual funds or ETFs whose underlying holdings overlap.

 Finally when building your portfolio, it's worth expanding the scope of your diversification to consider where your human capital lies. If you work in the energy sector for example, you might want to branch your investments to other areas so you don't take a double hit to your career and your investments should the industry falter. So whether you need to have a thousand baskets or just ten to protect your investments is up for debate. But either way it's not a hard egg to crack. Diversification reduces risk helping to offset your bad eggs with your good. and with that we're out of time and I'm out of egg idioms.

 If you have any feedback or topics want me to cover in a future video leave a comment down below 

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