By Ron Rice, Head of Marketing – Summit Global Investments
There’s an old diversification analogy involving eggs and baskets. You know the one. Don’t put all your eggs in one basket.
It’s good advice. But modern investing has made the basket considerably more complicated. Imagine putting your eggs into five different baskets—then discovering that all five baskets are being carried in the same truck. That’s closer to the diversification challenge investors face today.
An investor might own five mutual funds or ETFs, look at five different names on a statement, and reasonably conclude that risk has been spread around. Maybe.
But if those funds own many of the same companies, emphasize the same sectors, favor the same investment style, or respond similarly to the same economic conditions, the portfolio may be considerably less diversified than it appears. FINRA specifically cautions investors to look “under the hood” of funds for overlapping holdings and exposures because owning multiple funds alone doesn’t eliminate concentration risk.
Diversification Is About Behavior, Not Headcount
Here’s where we move beyond Investing 101. True diversification isn’t simply about how many investments you own. It’s about how differently those investments behave.
Investment professionals call this correlation—the degree to which investments tend to move together. Combining assets whose performance responds differently to economic and market conditions can potentially reduce the overall risk and volatility of a portfolio. Vanguard Investor
Think of a basketball team. You could put five terrific point guards on the court. Individually, they may be exceptional players. Collectively, you probably don’t have a very good basketball team.
Why? Because diversification isn’t about accumulating talent. It’s about assembling different capabilities. The same principle applies to portfolios.
Think of a basketball team. You could have five terrific point guards on the court. Individually, they may be exceptional players. Collectively, you probably don’t have a very good team.
The Risk You Can’t See
This is where diversification gets interesting. Suppose you own a large-cap growth fund, an S&P 500 fund,
a technology ETF, and another broad-market equity fund. Four investments. Four strategies. Four ticker symbols.
Yet when you examine the underlying holdings, you may discover many of the same large companies appearing repeatedly. That’s not necessarily bad—but it is important to understand.
Because what looked like four separate investment decisions may actually represent one much larger decision. And concentration doesn’t always happen intentionally. A successful investment can simply grow faster than everything around it until it quietly becomes an outsized portion of the portfolio. FINRA identifies this kind of performance-driven concentration as another risk investors should monitor. FINRA Sometimes your biggest risk is hiding inside your biggest winner.
Different Jobs for Different Investments
Thoughtful diversification starts by asking a better question: What job does each investment perform?
Some investments are intended to generate growth. Others may provide income. Some may seek stability. Others may respond differently to inflation, interest rates, economic contraction, or periods of heightened volatility. That can mean diversifying across asset classes, company sizes, sectors, geographies and investment styles—not simply adding another fund. Vanguard Investor
And sophisticated portfolio construction can go further. Risk-management strategies may be used to alter a portfolio’s risk-and-return characteristics rather than simply adding another traditional asset. These strategies may help manage certain portfolio risks, but they also involve trade-offs, including the potential to limit participation in market gains, introduce additional costs or complexity, and perform differently than intended under certain market conditions. The objective isn’t to eliminate risk—that’s impossible—but to make deliberate decisions about which risks to take, which to reduce, and how those choices fit within the broader portfolio.
It’s to decide which risks you’re willing to take, which risks you’re being compensated for taking, and which risks you’d rather manage. That’s a much more interesting conversation than counting funds.
Diversification Will Occasionally Disappoint You
There’s an uncomfortable truth about being properly diversified. Something you own will almost always disappoint you. That’s not necessarily evidence the strategy isn’t working. In fact, it can be evidence that it is.
If every investment in your portfolio is soaring simultaneously for exactly the same reason, congratulations on the performance. But you may want to ask how they’ll behave when that reason disappears.
Diversification means accepting that different investments will lead and lag at different times. The goal isn’t to own everything that’s winning today. It’s to build a portfolio that isn’t dependent on correctly predicting what wins tomorrow.
Investor IQ Takeaway
Owning more investments isn’t the same as owning different risks. Look beneath the fund names. Understand what you actually own, how those investments interact, and what role each plays in the portfolio. Because the real measure of diversification isn’t the number of lines on your investment statement. It’s the number of different answers your portfolio has when the market asks a difficult question.
