The basic rule in managing a portfolio is to follow the classic advice “Do not put all your eggs in one basket.” Things can go wrong and you do not want to get badly hurt with any particular future outcome. Generally, diversification is one of the few free lunches in investing. By diversifying, you reduce risk and do not reduce expected return.
Recognizing that the future is uncertain, investors need to take investment decisions that take into account the fact that their investments may not turn out the way they thought they would at the time of making the investment. This is applicable even to investors who have an appetite for bearing high levels of risk. You don’t want freak accidents and events wiping out your future.
You believe you have identified the perfect stock to invest in. You expect it to deliver handsome returns over a long period of time.
You have a choice. You could invest all your available money into it, or you could invest a part and the remaining in some other stock.
By investing all in that one stock you are giving yourself the best chance of a good return. However, you are also exposing yourself to a high level of risk as it is an individual stock exposed to events, circumstances, cycles and other vagaries. By not investing the entire amount in this single stock, you are probably going to earn lower returns, but you are protecting yourself against the risk of a total wipeout in the event of a freak incident derailing that one investment.
Diversification can be done at many levels.
You could invest in the stock of another company in the same industry.
You could invest in the stock of a company in a different industry, giving you additional protection against a freak incident impacting the original industry.
You could invest the remaining amount in a mutual fund, gaining greater protection with exposure to a basket and not individual stocks.
You could invest the balance in fixed income securities such as bonds, gaining further protection against the vagaries of a single market, the stock market.
And so on.
The risk of investing in risk-prone products such as individual stocks can be substantially reduced by investing in a diversified portfolio of individual stocks.
If diversification is so important, why do we prefer a single index fund for equity rather than diversifying among a number of funds?
We suggest that your asset allocation strategy looks to determine the amount of equity risk that is a good match for you and then use the funds to get exposure to the desired level of equity risk.
A good broad index fund gets you exposure to a diversified basket of stocks. In comparison, while a number of equity funds will give you more diversity than a single fund, they all have exposure to a list of stocks. If you calculate the list of stocks that you have through the many funds, you will come up with a list which is diversified but probably less diversified than a single index fund.
There is often a lot of overlap among different funds and the underlying exposures may get to a similar level of diversity than a single index fund. Our favourite equity index fund where possible is the one that invests in the global stock market. Invest in every public company in proportion to the amount of free float market value of the equity outstanding. It is hard to get more diversified equity exposure than this single index fund, no matter how many equity funds you buy. As you buy more funds, the diversification will ensure that your returns before fees get closer to the market. The overall diversification will be worse or equal to the index fund. The costs of active funds are much higher than index funds and in the long run, your after-tax returns are likely to be lower unless the mutual funds outperform as a group. If you are actually picking active funds, it is better to stick to a small list rather than a large number of funds.
You can learn more about diversification here
https://www.investopedia.com/investing/importance-diversification/
