Diversification is an essential tool available to investors. It enables them to capture broad market forces while reducing the uncompensated risk associated with individual securities. Our investment strategies draw heavily upon this philosophy.
We believe successful investing means not only capturing reliable sources of expected return but managing diversifiable risks and other risks that do not increase expected returns. Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, speculating in areas like interest rate movements, and relying solely on information from third-party analysts or rating services. To all these, diversification is an essential tool available to investors. While it does not eliminate the risk of market loss, diversification does help eliminate the risk of holding individual securities and positions your portfolio to capture the returns of broad economic forces.
Dimensional’s strategies diversify not only in the amount of securities they hold but in the range of capital markets they explore and develop. In this way, strategies are designed to focus on the factors that drive investment returns while reducing excess and undesirable risk.
Diversification is much more than the idea of not putting all your eggs in one basket. We know that stocks that share similar risk factors tend to move together. This can dramatically reduce the benefit of owning multiple stocks in a portfolio. For example, if a portfolio of stocks move in perfect correlation, there is little reason to own more than one. Combining stocks in a portfolio that move in tandem is what we call “ineffective diversification” because risk is not reduced.
Alternatively, “effective diversification” does help to reduce risk. An effectively diversified portfolio is constructed of securities, or preferably entire asset classes, that do not share common risk factors and therefore tend not to move in concert with each other. These portfolios have components that “zig” while others “zag,” creating more consistent, less volatile returns. Effective diversification should not only help you sleep better at night, but also your money may compound at a greater rate compared to a more volatile portfolio with the same average return.Diversification does not eliminate the risk of market loss.