Diversification strategy: From Harry Markowitz to today's best practices

Advantages of diversification

Diversification offers several benefits that help investors manage risk and create a more stable portfolio.

Risk reduction

A diversified portfolio reduces the impact of poor performance from any single investment. When assets respond differently to market conditions, losses in one area are often balanced by gains in another. This approach helps smooth overall portfolio performance and minimises exposure to unsystematic risk.

Greater stability

Diversification promotes long-term portfolio stability. Spreading investments across asset classes and regions limits the effects of market volatility. This is especially valuable during periods of economic uncertainty, as it reduces the likelihood of significant losses.

Access to broader opportunities

Investors benefit from exposure to a wider range of markets, industries, and geographies, because this access increases the chances of identifying growth opportunities and capitalising on them–whether in emerging markets, innovative sectors, or alternative investments.

Protection against sector-specific risks

Concentrating investments in a single sector increases vulnerability to industry-specific downturns. Diversification across multiple industries mitigates this risk, ensuring the portfolio remains resilient even when one sector underperforms.

Disadvantages of diversification

While diversification is often a helpful strategy, it comes with its own set of drawbacks that investors should consider.

Diluted returns

Spreading investments across multiple assets often limits the potential for outsized gains. When high-performing investments are combined with weaker ones, the overall portfolio return may be lower compared to a concentrated approach.

Increased complexity

Managing a diversified portfolio requires significant effort. Monitoring various asset classes, geographies, and industries can become complex, especially for individual investors. Ensuring that allocations remain balanced and aligned with goals adds to this challenge.

Higher costs

Diversification may lead to additional expenses. Transaction fees, fund management charges, and advisory costs can accumulate, reducing the net returns of the portfolio. This is particularly relevant for investors using active management strategies. The more trading you do to create and rebalance your portfolio, the more you will spend on fees and commissions. More complex portfolios require more rebalancing.

Over-diversification risks

Over-diversification occurs when a portfolio includes too many assets, diluting potential gains and increasing management difficulty. Holding excessive investments can result in diminished returns, as well as overlapping exposures that fail to achieve true risk reduction. Most investment strategies rely on the long-term performance of equities, which tend to increase in value over time. Over-diversification (by also including bonds, gold, and so on) may reduce exposure to this value-creating tendency.

Practical steps to build a diversified portfolio

A diversified portfolio requires clear objectives, disciplined planning, and regular adjustments to help ensure better resilience against market fluctuations.

1. Set clear investment goals and assess risk tolerance

Establishing financial goals is the foundation of a strong portfolio. A longer timeline allows for a focus on growth assets like equities, while short-term objectives often call for more stable investments such as bonds. Understanding personal risk tolerance ensures that portfolio choices align with the investor's ability to handle potential losses.

2. Allocate assets across asset classes

Spreading investments across multiple asset classes reduces reliance on a single type of asset. A balanced allocation, such as the traditional 60/40 split between stocks and bonds, provides stability and growth potential.

Aggressive investors might consider an 80/20 mix, while more conservative approaches could favour a 50/50 allocation. Adding real estate, commodities, or alternative assets may strengthen the portfolio even further.

3. Diversify within asset classes

Building variety within each asset class adds another layer of protection.

• Stocks. A combination of large-cap, mid-cap, and small-cap equities across sectors like technology, healthcare, and consumer goods.
• Bonds. Mixing government and corporate bonds, along with different maturity lengths, balances risk and reward.
• Alternatives. Real estate through REITs or tangible assets like commodities provides stability and hedges against inflation.

4. Include geographic diversification

Expanding investments beyond domestic markets helps reduce exposure to any single economy. Developed markets offer stability, while emerging markets present opportunities for higher returns. A mix of both ensures balance.

5. Rebalance periodically

Over time, some assets outperform others, disrupting the intended allocation. Rebalancing ensures the portfolio remains aligned with the original strategy and risk profile. Regular reviews prevent imbalances from reducing diversification benefits.

6. Monitor costs and liquidity

Transaction fees, management expenses, and liquidity constraints can affect portfolio performance. Balancing liquid assets for short-term needs with long-term investments ensures flexibility without compromising return

Portfolio allocation example

A diversified portfolio for a moderate-risk investor might include:

• 50% stocks. Divided across domestic, international, and small-cap equities.
• 30% bonds. Combining government and corporate bonds.
• 10% real estate. Accessed through REITs or direct investments.
• 10% commodities. Examples include gold or agricultural ETFs.

This structure balances growth potential with risk management and is adaptable to individual goals. A higher percentage of equities may be appropriate for a higher-risk or longer timeframe investor.

Diversification and risk management

Diversification is an essential tool for managing risk in an investment portfolio. It helps reduce vulnerabilities while balancing returns, but it is important to also understand its limitations and practical applications.

Systematic vs. unsystematic risk

Diversification primarily addresses unsystematic risk, which is specific to individual companies or sectors. This includes risks like management inefficiencies, regulatory challenges, or sector-specific downturns. A well-diversified portfolio spreads investments across assets that respond differently to market events, reducing exposure to such risks.

Systematic risk, however, impacts the entire market or economy and cannot be eliminated through diversification. Events like recessions or geopolitical instability affect all asset classes to some degree. While diversification helps manage these risks, additional strategies such as hedging can provide further protection.

Correlation and volatility

Diversification works best when assets in a portfolio have low or negative correlations. This means they do not move in the same direction under similar market conditions. For instance, equities and bonds often show low correlation, making them a strong combination for reducing volatility.

Measuring correlation coefficients allows investors to evaluate the diversification quality of their portfolio. A coefficient closer to -1 suggests substantial diversification benefits, while a coefficient closer to +1 indicates minimal risk reduction. Often, uncorrelated assets (coefficient close to 0) are preferred, since lower coefficient assets will eat more significantly into returns.

Hedging strategies

Hedging complements diversification by protecting against specific risks. Using hedging strategies requires careful consideration of costs and potential losses, which can impact overall portfolio performance. These strategies are best applied alongside diversification to create a more robust risk management framework.

Case studies and real-world applications

Diversification offers valuable lessons, both in its successes and its shortcomings. Examining real-world examples can give us insights into how investors can balance risks and returns effectively.

Effective diversification in practice

During the 2008 financial crisis, portfolios that combined equities, bonds, and alternative investments performed better than those heavily concentrated in a single asset class. Many stock portfolios were overexposed to banking stocks which suffered the most during the crash due to their strong performance in the years leading up to 2007. A similar situation emerged during the ‘dot com bubble’ of 2000-2001, where tech stocks enjoyed a run of outsized performance before experiencing severe losses.

In a generalised market crash, investors exposed to domestic and international markets can mitigate losses through stable assets like government bonds and commodities like gold. This approach preserves capital during extreme market volatility and helps with recovery when stability returns.

For example, a 2007 portfolio holding 40% equities, 40% bonds, and 20% commodities would demonstrate resilience compared to one weighted entirely in equities. Although a cautious portfolio like this may experience lower gains during stock market booms, during downturns it could outperform, as losses tend to be concentrated in volatile equity markets.

When diversification falls short

Over-diversification is a potential pitfall for investors. In the past, some large funds have struggled due to holding excessive numbers of assets, many with overlapping characteristics.

For instance, public pension funds in the US have faced criticism for managing large, complex portfolios which do not beat their benchmark, often including alternative assets and with limited transparency.

Relying on correlated assets is another issue. The dot com bubble of the early 2000s exposed the risks of concentrating investments in a single sector, even if diversified by geography and company. Investors heavily weighted in technology stocks saw massive losses as the bubble burst, underscoring the need for a diversified strategy that includes uncorrelated assets.

Conclusion: Diversification can help with portfolio stability

Diversification is your best defence against uncertainty. No one can predict the future, but spreading investments across uncorrelated assets can help ensure you are not overly exposed to any single risk. A well-diversified portfolio doesn't just try to protect against potential losses, but it can also help position you for consistent performance over time in most market environments.