One of the oldest cliches in investing is that diversification is the only free lunch. Is this true? Sort of. In this post we’ll explore why and when diversification works and its limitations. We’ll also look at how investors can diversify their investments in practice.
What is diversification?
Diversification simply means spreading your money across more than one investment or “not putting all your eggs in one basket.” This can be by investing in a variety of companies, sectors or types of investments.
If our investments behave differently, we should see a smoother path of returns than if we just invested in a single investment. In other words, our portfolio will be less volatile. This is because, even if markets are falling overall, not all our investments will fall by the same amount and some may even rise in value, which will reduce the loss on our portfolio.
Diversification works both ways. We’ll also see smaller peaks in our portfolio in rising markets, as not all our investments will rise by the same amount and some investments may lose value.
The theory1 goes that, in the long-run, we should not see a reduction in returns from diversifying our portfolio – hence the free lunch. We’ll return to this later on; however, first, lets explore why and when diversification works.
Why does diversification work?
Investments behave differently for a variety of reasons. Companies in the same part of the economy may perform differently, depending on the actions of their employees and management. In 2024, tech stock share prices rose dramatically, however there was huge dispersion within the sector. NVIDIA’s share price surged by 142% in 2024, however Intel’s fell by 60%.
Various parts of the economy will also fare differently. For example, while technology and communications sectors performed very well in 2024, it was as relatively poor year for companies in the materials sector (mining, refining and chemicals).
Different asset classes will also behave differently. For example, equity prices tend to go up when investors are positive about the economic outlook. However, when investors are more pessimistic, they may favour the relatively safety of government bonds.
In How to think about investment returns, we explored how the returns of an investment can be decomposed into various risk premia. These risk premia behave differently, so selecting investments exposed to a variety of risk premia should improve diversification.
The fortunes of investment managers will also vary. Some will make the right calls, some will make the wrong calls, and some will make the right calls but get unlucky. Therefore, if we are relying on manager skill to deliver some of our returns, we may wish to diversify across different managers. If so, we should aim to invest in managers with a variety of approaches, for example managers who like to pick individual stocks based on how they view companies (“bottom up”), versus managers who like to take positions based on views about the economy (“top down”).
When does diversification work..
Diversification works well when assets behave differently. If there are lots of things going on in markets and the economy, with no single dominating theme, then the various investments in our portfolio will be pushed and pulled in different directions and diversification should help smooth out returns.
..and when doesn’t it?
However, if a single event dominates, then diversification may not be as effective.
Diversification famously didn’t work very well at the height of the 2008 credit crunch. For a moment, when Lehman Brothers collapsed in September 2008, it felt to many like the financial system was close to collapse. Once fear takes hold, anything that looks risky will look unattractive.
The chart below shows returns on a selection of assets in October 2008. The only assets to have positive returns where those perceived to be safe havens at the time, like short-dated US government bonds. Even gold, which had traditionally been seen as a safe-haven asset, suffered a large price drop at the height of the crisis. We’ll discuss this more in a future post, when we explore the role of illiquidity in the 2008 financial crisis.
Diversifying in practice
Investing in a broad portfolio of company shares is straightforward and cheap. Funds that seeks to track one of the major equity indices, such as the S&P 500 in the US or the FTSE 100 in the UK (these are called “passive” funds) can have management charges less than 0.1% and are readily available on many different investment platforms.
However, there is more work to do if we want to invest in more than one type of investment (equities, bonds, cash etc.). We need to decide which investments to buy and how much to allocate to them. We also need to choose investment managers. All this takes time and expertise. Institutions will usually take professional advice from an investment consultant when allocating to different investments. Individuals can take advice from an Independent Financial Advisor.
We can also delegate these decisions entirely. Institutions may appoint a fiduciary manager or an outsourced chief investment officer to manage their strategy. Individuals may appoint a discretionary investment manager.
Another option is to invest in multi-asset funds. These contain a mix of different assets, and may be labelled as mixed funds, balanced funds or diversified growth funds, depending on the provider.
Multi-asset funds may have an overriding risk and return objective – a real-life example is “to outperform cash by 4.5% over a 5–7-year period, with less than two-thirds the level of equity market volatility” – or, they may seek to maintain a stable allocation to different assets classes, for example 60% in equities and 40% in bonds.
A benefit of these funds is that they enable investors to piggyback off the scale of the investment manager, to invest in assets that they wouldn’t normally be able to access as an individual, like hedge funds and catastrophe bonds.
A free lunch?
Any of the above options will incur a fee, in addition to the cost of investing in the underlying assets. We will also need to do the work of choosing the adviser, discretionary manager or multi-asset fund. So, in this sense, although diversification is an important risk management strategy, it isn’t really a free lunch.
Big picture diversification
When considering our own financial situation, we may find that there are hidden risks that we need to consider. This may then affect whether we decide to add more of an investment to our portfolio.
For example, consider equities, whose returns are driven by the fortunes of companies and the economy. All the following may have some equity risk; some are obvious, some less so.
- Equity funds in an Individual Savings Account or general investment account.
- Equity funds in a company defined contribution pension.
- Equity funds held in a multi-asset fund, in either of the above.
- Shares in the company you work for, which you have purchased using a Share Incentive Scheme.
- Shares in the company you work for, that have been awarded to you as part of your annual compensation.
- An annual cash bonus, if this partly depends on the share price of the company you work for.
- Your salary and job security, if the company you work for is in an industry that is sensitive to equity market performance (which is the case for many companies in financial services, for example).
Failure to consider the big picture can leave us with a poorly diversified asset mix overall.
- Most famously Modern Portfolio Theory, developed by Harry Markowitz in the 1950’s. ↩︎
- Sources: curvo.eu/backtest, http://www.bullion-rates.com. Global equities represented by MSCI World index, Euro high yield represented by iBoxx € Liquid High Yield index, Property represented by Dow Jones Global Select Real Estate Securities index, US corporate bonds represented by iBoxx $ Liquid Investment Grade index, US government bonds represented by ICE US Treasury 1-3 Year Bond index. ↩︎
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