The above quotation has been attributed to the late Nobel laureate Merton Miller, an economics professor from the University of Chicago, when asked to sum up the most important investment concept individuals should know. Building a portfolio that is globally diversified is one of the primary keys to long-term investment success.
Diversifying a portfolio involves combining many different types of assets in order to reduce the overall level of risk. There are three primary levels of diversification:
1. At the portfolio level – Asset allocation is the process of spreading investments among stocks, bonds and cash in order to achieve the desired risk and return tradeoff that is aligned with an investor’s specific situation. Asset allocation is one of the most important factors in the successful implementation of any investment strategy. Many academic studies have demonstrated the overall importance of asset allocation. The most famous of these studies, Brinson, Singer and Beebower (1991), found that asset allocation explained 91.5% of total portfolio variability.
2. At the asset class level – There are many different asset classes found in stocks, bonds and cash and not all of them move up or down at the same time. Combining asset classes that do not tend to move in a similar direction (or those that have a less than perfect correlation if you’re a finance geek) is another way to add a level of diversification to a portfolio. For example, diversification among equities can be achieved by combining value and growth, large and small domestic, and international developed and emerging market stocks. Diversifying in this manner can help ensure that, while not all investment dollars will be allocated to the best performing assets classes, they will not all be invested in the worst performing asset classes either.
3. At the individual security level – Academic research has demonstrated that a certain amount of market risk cannot be diversified away because the risk is inherent within the market itself. This is called systematic risk. However, a portion of an individual stock’s risk profile includes non-systematic risk, or risk that is unique to the company and industry. This type of risk can be mitigated by holding many different kinds of stocks. This is why an individual stock is much more risky than a diversified portfolio.
The more diversified the portfolio, the more likely that losses will be offset by other investments that are doing well. While diversification does not guarantee a positive return or prevent losses, especially when a crisis hits, over time it is a key determinant of a successful investing experience. Over the long haul, academic research and experience has proven that diversification pays off in both higher returns and reduced risk.
