Diversification, often hailed as the only "free lunch" in investing, is a strategy that entails spreading investments across various asset classes—such as stocks and bonds—to manage risk and enhance potential returns. The theory, popularized by Nobel laureate Harry Markowitz, suggests that by holding a broad mix of asset classes, investors can reduce the overall risk in their portfolio without sacrificing returns. Despite the benefits that diversification can provide investors, the practical implementation is not as straightforward or free as the above adage would suggest. This article delves into the nuances of diversification and explores the behavioural challenges that it entails.

The theory behind diversification

Diversification is a crucial concept for investors to understand. It acknowledges that the future is inherently unpredictable and can unfold in numerous ways. After all, if the future was predictable, then we’d simply be fully invested in a single best-performing investment. Since this is not the case, investors can mitigate their risk and provide protection against uncertainty by holding a variety of investments with different characteristics. This is based on the principle that different asset classes—such as stocks and bonds—can perform differently under the same market conditions. As the negative performance of one asset can be offset by the positive performance of another, diversification can provide greater stability to overall portfolio returns. Diversification can be extended further by including securities with different attributes within each asset class. For example, within equities, this can involve including companies across different sectors of the economy, geographies, and market capitalizations.

The concept is theoretically sound and supported by many studies showing that diversified portfolios tend to have less volatility and better risk-adjusted returns over the long term. It's also a simple concept to implement, however, it requires discipline to maintain. Practicing diversification effectively requires investors to understand and master some of the behavioural challenges that come with this approach.  

Behavioural challenges of diversification

The most significant challenges of maintaining a diversified portfolio are behavioural in nature and require us to overcome our natural human biases. Inescapably, diversification involves holding investments that will outperform alongside those that will disappoint. In fact, in order for a portfolio to actually be diversified, it requires a portfolio to hold underperforming investments. If all components of the portfolio were performing well in unison, then the portfolio is likely not diversified. Herein lies the challenge with a diversified portfolio—being able to accept this reality and resist the urge to shed the slackers in favour of the strong performers. 

While it would feel better and less risky to have a portfolio full of winners it would only provide temporary comfort and almost certainly lead to increased risk and long-term disappointment.

This is due to the cyclical nature of the markets whereby today’s outperformers typically become underperformers at some point in the future. Conversely, by maintaining asset classes that are underperforming today, outperformance will likely happen down the road which will help bolster future portfolio returns later on.