Why is diversification so important?

Let’s face it, in today’s environment the world of finance has gotten so overly complicated and convoluted that the majority of us have no clue what to expect. It is a gamble out there. Even the professionals who claim to be prophets are contradicting each other’s statements. If you just spend 5 minutes on yahoo finance or any other finance website you’ll see 2 articles written by two different professionals with completely opposite predictions albeit each of them having years of education and experience. Just take a look at my last post to see how the “professionals” have performed in recent history…it doesn’t take long to realize that you as an individual investor with little to no experience can do just as well.

What exactly is diversification?

In my first article I discussed taking away specific risk by holding more than one stock and illustrated a graph showing the effect of holding multiple stocks. Essentially what occurs is the risk of one company failing is dampened by the success of others…but it doesn’t mitigate the risk of all the companies failing at once -- that is called market risk. It isn’t that easy though, if you read the fine print (as you should learn to do in the finance world) and learn the assumptions made in the graph you’ll notice the word “uncorrelated”. Correlation is the biggest determinant in the success or failure of your attempt to diversify. Simply holding 20 stocks doesn’t necessarily mean you are better diversified than holding 10 stocks. Correlation is a statistical measure of how two securities, or asset classes, move in relation to each other. Say for instance every single time the S&P 500 goes up 5%, your stock also goes up 5%...well then you have a correlation of 1.00 (which means you aren’t diversified at all). The whole point of diversifying your portfolio is so that when the market crashes it doesn’t take your portfolio down with it. The opposite though can be true too, you don’t want a -1 correlation because then every time the market booms you’ll be losing money. The ideal situation would be to have no correlation at all to the market and yet still have positive returns. Take a look at the chart below comparing the correlations to the S&P 500 and each asset class return and risk. – Source: Morningstar

	Correlation	Return	Std Dev.
Large Cap	1	3.14	15.65
Mid Cap	0.97	7.5	18.38
Small Cap	0.96	7.4	20.72
International	0.9	6.62	19.58
Emerging Market	0.86	15.36	24.52
REIT	0.81	9.86	25.5
High Yield Bond	0.73	6.75	9.12
TIPS	0.25	6.93	6.92
Total Bond	0.08	5.25	3.79
Gold	0.07	21.9	20.29

As you can see Bonds and Gold do not have any relationship to the stock market. Correlation has no relationship to return or individual risk. So what is my suggestion? Why not just spread your bets evenly across the board and keep your life simple and safe. By spreading your bet evenly you’d have returned a little over 9% with half the amount of risk…not bad if you ask me.