Successful investing means not only capturing risks that generate expected return but also reducing risks that do not. Avoidable risks include holding too few securities, betting on individual countries, industries, or sectors, following market predictions, and speculating on buy or sell recommendations from securities analysts.
Diversification is the antidote to all of these potentially damaging mistakes. Diversification helps to minimize the random outcomes of individual stocks, and positions your portfolio to capture the returns of broad economic forces.
Diversification is much more than the idea of not putting all your eggs in one basket. We know that stocks that share similar risk factors tend to move together. This can dramatically reduce the benefit of owning multiple stocks in a portfolio. In a simplistic example, if a portfolio of stocks move in perfect correlation, there is little reason to own more than one. Combining stocks in a portfolio that move in tandem is what we call "ineffective diversification" because risk is not reduced.
Alternatively, "effective diversification" does help to reduce risk. An effectively diversified portfolio is constructed of securities, or preferably entire asset classes, that do not share common risk factors and therefore tend not to move in concert with each other. These portfolios have components that “zig” while others “zag,” creating a more consistent, less volatile net return series. Effective diversification should not only help you sleep better at night, but also your money may compound at a greater rate compared to a more volatile portfolio with the same average return.
Combine Multiple Asset Classes
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Seek to combine multiple asset classes that have historically experienced dissimilar return patterns across various financial and economic environments.
Diversify Globally
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More than half of the market value of global equities is located outside the United States. International stock markets as a whole have historically exhibited dissimilar return patterns to the U.S. markets.
Invest in Thousands of Securities
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Compared to a portfolio concentrated in a small number of securities, investing in thousands of securities around the world can limit portfolio losses during a severe market decline by reducing company-specific risk.
Invest in High-Quality, Short-Term Fixed Income
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We believe the role of fixed income in a diversified portfolio is to reduce volatility while producing income. We seek to accomplish this by utilizing short-term, high-quality securities that have a low correlation with stocks and strong credit quality.