Why (and How) Diversification Works

 

A common perception today among investors is that diversification hasn’t worked because diversified portfolios have delivered lower returns than U.S. stocks in recent years. Yet, that’s exactly how diversification should work.

 

A diversified portfolio will always under-perform the best performing asset class, which lately has been U.S. stocks. This is why diversification should not be viewed as a return enhancer, but rather a risk management tool that can reduce risk without necessarily reducing absolute returns (the return that an investment earns independent of any benchmark). However, diversification comes with trade-offs. Diversifying may cause you to risk experiencing lower relative returns (the return that an investment earns relative to a benchmark) for a period of time.

 

A Comparison

 

To help understand diversification’s trade-offs, let’s look at a simple comparison. Imagine that you’re a Florida resident whose friends have beach house rentals that yield 10% a year. Now imagine that you have the opportunity to earn the same yield as your friends by investing in either 1) two Florida beach houses or 2) one Florida beach house and one Tennessee mountain cabin.

 

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