Why Diversification is Important in Investing: Benefits, Strategies, and Asset Allocation Insights

Harry Markowitz won the Nobel Prize in 1990 for his work in showing mathematically how to reduce risk and create better returns by diversifying across regions and assets. Risk is measured in volatility, i.e. how your assets fluctuate in price. Such a theory was new when it was first released in the 1950s, and Markowitz said it’s the closest thing you get to a free lunch.

This article discusses why diversification is important in investing, and in the end, I write how I have allocated my capital between several different asset classes.

We can question how valuable volatility is for measuring risk, but to me, it makes sense because of the behavioral mistakes that follow big moves on the downside. When we are fearful, we tend to do irrational things. Furthermore, research shows retail investors underperform the market substantially, and two of the reasons are overconfidence and lack of diversification.

Systematic and unsystematic risk (diversification matters)

The risk in the stock market is divided into two parts: systematic and unsystematic risk.

Systematic risk refers to the risk in the entire market. For example, the sum of all stocks goes either up or down, which is impossible to diversify, is called systematic risk. This is a risk you can’t avoid.

Opposite, we have unsystematic risk that refers to a specific company or industry. Example: If you buy all the stocks in the S&P 500 adjusted to market capitalization, you have diversified all unsystematic risk for that asset and only have systematic risk, which you can’t control. Opposite, if you only buy Foot Locker, you are obviously dependent on the performance of that stock. This means you put on substantial unsystematic risk.

But the beauty of diversification is that you can invest in other assets besides stocks: real estate, gold, bitcoin, bonds, hedge funds, etc. In that way, you have returns that are not correlated (hopefully). This means, for example, stocks might go down, but your assets in gold and bonds might, in the same period, go up.

Back to stocks: The graph below shows how many stocks you need to own to limit unsystematic risk (based on simulations on the Oslo Stock Exchange). With 10 stocks, you have reduced unsystematic risk substantially, and the marginal utility to include more stocks is pretty low. This means you only need 8-15 stocks on the Oslo Stock Exchange to limit most unsystematic risk.

Women are better investors than men because they diversify

Research shows women are better investors than men. Why is that? The main reason is that men take on more unsystematic risk in their portfolios. Pareto Securities wrote a blog post (in Norwegian) about diversification and how retail investors gravitate toward few and inherently risky stocks (titled Hvordan Tjene Mer På Aksjer).

In their unofficial survey, only 25% of the retail investors owned more than 7 stocks! The combination of few and riskier stocks usually doesn’t end well.

Some words about Warren Buffett and diversification

Warren Buffett is not an advocate of diversification. He claims volatility is a poor risk measurement, and diversification usually leads to “diworsification”.

It makes sense because you only need a few good investments to compound and become wealthy. But what are the chances that the average retail investor will