The Importance of Diversification

A recent article in Vanguard argues that diversification is the best way to control the risk that is necessary to generate portfolio returns.

Here are the main takeaways:

Fund type matters: While equity funds can spread holdings across a range of shares, the level of diversification accomplished varies with the type of fund: “A fund that  focuses solely on a certain part of a particular market, such as UK smaller companies, won’t give you as much diversification as one that invests in the whole market.”

More funds are not necessarily better: The article warns investors that more funds don’t necessarily increase diversification: “Combining funds that have similar holdings will give you little or no diversification benefit.”

Asset class: Diversification across asset classes is important, since they tend to behave differently: “This means that when the value of one type goes down, there’s a good chance that you’ll benefit from prices going up somewhere else.” The article suggests, “A tried and tested way of diversifying by asset classes is to combine shares and bonds. Equities should perform better over the long term but they’re likely to be choppier in the short term. Bonds, on the other hand, are less volatile – that is to say, their prices move around less in the short term – so they help to control risk.”

Geographic diversification: “To achieve good levels of diversification we believe it’s best to have broad exposure to equity and bond markets across the globe.”