Immediately after those statements, you're told to purchase some combination of small, medium, and large cap stocks or bundles of these stocks in a mutual fund or ETF. You may even hear something like allocating a certain percentage of your money into stocks & bonds based on your age. Typically, these are the broad options given to you by your first financial advisor.
But don't be fooled; these things don't mean you're diversified.
“Diversification" is actually the level of correlation between the investments in your portfolio. Correlation is how prices (and your returns) change with respect to one another. Do they go and down at the same time by the same amount? If yes, then they’re said to be correlated and visa versa.
our portfolio’s considered “diversified” when the returns of your investments are "uncorrelated“. When returns are “correlated”, your investments are "undiversified".
Safe Investing Tip:
If all your investments go up in price at the same time, then your portfolio IS NOT diversified.
The expectation is that by allocated your portfolio dollars to different assets, techniques, and/or strategies, no single investment will determine your portfolio’s performance over time (i.e. you limit the risk that a loss in one investment wipes you out).
It’s the whole “don’t put all your eggs in one basket” anecdote.
You could say that these factors are “built in” because you’re deciding how much money to put at risk for each type of investment before buying anything.
Here are some asset allocation strategies for you to achieve diversification:
Divide the “covariance of the portfolio returns and market returns” by the “variance of the market return”.
Most investors don’t have the interest (or historical data) to do so. So instead of doing the math, the industry uses proxies and rules of thumb based on the math.
Basically, you’re diversified when your portfolio includes a variety of uncorrelated returns.
For example, investment vehicles within an asset class tend to be highly correlated. In William O'Neils book "How to Make Money In Stocks", he describes the historical phenomenon that 3 out of every 4 stocks follow the "market" trend. So 75% of stocks will move in the same direction as the overall market indexes that you see on the news every evening. (i.e. they’re highly correlated).
Think of it this way: A dinner plate may have 10 different types of meat, all with different of colors, textures, and tastes. it’s still a plate full of meat (not diversified).
In order to have a healthy body, you need nutrients from different food groups, along with exercise.
In order to have a diversified investment portfolio, you need returns from different asset classes, along with process-based investing techniques and strategies.
Jim Cramer has a Mad Money segment called "Am I diversified?", when viewers list of 5 stocks, usually from different sectors, and ask if they're diversified. Or he commonly says that your first $10,000 should go into an index fund.
Now, there's nothing "wrong" with investing in a combination of small, medium, or large cap stocks. There's nothing "wrong" with investing in stocks that represent a variety of market sectors.
If you decide to buy and hold an index ETF, or a even a bunch of different stocks, you still only 1 asset class (equities) and are getting a small amount of diversification.
Since the price movement of equities are highly correlated to one another, your “investment” (ETF or otherwise) is at a higher risk of loss if/when something bad happens to stocks. That’s it.
Going back to our initial example, when an investment advisor pitches a portfolio of stocks and bonds, you’d be in two asset classes with returns that aren’t correlated most of the time. It’s common for some to throw in a gold investment to cover 3 asset classes.
In both cases, your correlation would be as lower compared to the portfolio that only contained stocks (representing 1 asset class).
Each asset class tends to be impacted by different factors, so returns are expected to be relatively independent (they’re uncorrelated).
You could further diversify by having part of your portfolio in a “buy and hold” technique (e.g. stocks and bonds from the example above), and a second part “actively managed” (gold).
Safe Investing Tip:
Asset classes CAN and DO move in the same direction under certain circumstances! The financial crisis in 2008 is a great example.
Correlations change over time. The last 6 months may be different than the prior 6 months, or the last 18 months. That's why it’s also important to understand factors affecting the asset classes you purchase (market conditions, where we are in the business/credit cycle, etc.).
In fact, some people say de-worse-ification, referencing the fact that you are knowingly buying things that will give you losses for the sake of less risk.
That’s the same thing as insurance, and you have that on your largest purchases – why wouldn't you have something similar for your portfolio?