The glossary

Diversification

Diversification in finance refers to the strategy of allocating capital across a variety of different investments to reduce risk. This process involves investing in assets that vary in nature and behavior, thus minimizing the impact of market volatility or the underperformance of any single asset. The opposite of diversification is concentration.

• Risk mitigation: It’s all about not putting all your eggs in one basket. By spreading your investments across different sectors, asset classes, or even geographies, you’re essentially building a safety net against significant losses.
• Balance: Diversification isn’t just about risk; it’s about balance. It skillfully offsets the underperformance of some assets with the solid performance of others.
• Long-term strategy: Diversification is considered a fundamental approach for long-term investment strategies.

Asset behavior: Effective diversification requires understanding the unique behaviors of different assets. The goal is to invest in assets that do not mirror each other’s movements, reducing overall risk.

Return vs. risk: While the aim is to be protected against losses, it also impacts the potential range of returns. Narrowing down too much could mean missing out on higher gains.

Complexity: The process of diversification is not just about spreading investments; it’s also about understanding and managing them. Overdiversification can lead to a scenario where managing a large number of investments becomes overwhelming and counterproductive.

Striking a balance: Finding the right level is crucial. Too little exposes the investor to high risk, while too much can lead to a diluted focus and sub-optimal returns. The art lies in balancing the number of diversified assets to match one’s investment capacity and goals.

Harry Markowitz, a Nobel laureate in Economics, famously stated in 1959, “Diversification is the only free lunch.” This highlights the idea that it can improve the expected return for a given level of risk, as assets do not consistently outperform every year.

The concept is also deeply rooted in history. Ancient texts suggest a strategy of dividing investments into one-third in land, one-third in business, and one-third in cash.