Diversification – what is it?

Diversification is the process of holding combinations of securities in a portfolio that have different risk, return and correlation characteristics, that has the effect of reducing (not eliminating) volatility risk relative to a less diversified portfolio or single-security with the same stock/bond mix. As a simplified example, if an investor holds only one airline stock in a portfolio, the investor is subject entirely to the risks of that company and industry. The largest cost of doing business for airlines is fuel. When fuel prices spike or drop, that can have a significant impact on the stock market price of the airline. If that same investor were to add an oil company to his/her portfolio, the stock price of an oil company generally rises as oil prices rise, and that stock price pattern can offset the typically weaker periods of the airline stock price. By combining the two, the investor might receive a similar average return over time, but should experience less overall volatility, due to the diversification effect. And, mathematically, for the same rate of return, lower volatility increases the compounding rate of return of a portfolio. That said, holding only two stocks is not considered a “diversified portfolio”. A well-diversified portfolio may hold hundreds or thousands of stocks and bonds, across an array of sectors, industries, market capitalizations (i.e. company sizes) and countries. WealthStep builds portfolios with very high diversification to help control risk, consistent with the markets.