The Benefits and Challenges of Diversification

There’s a saying in finance that “there’s no free lunch, aside from diversification.” The underlying meaning is that nearly everything in investing requires a trade-off. If you want to position your portfolio to have a higher expected return, you have to accept greater risk as measured by volatility.

Conversely, if you decrease the risk in your portfolio, you also accept a decrease in your expected return. Thus, the concept that there’s “no free lunch.” The one exception, however, lies in an investor’s ability to eliminate company-specific and industry-specific risk, also called idiosyncratic risk.

How Investors Decrease Risk Without Decreasing Returns

When you spread out investment allocations across numerous companies and industries, the risk specific to any individual company or industry is diversified away and the only risk remaining is market-wide risk.

Diversifying that idiosyncratic risk across equities with a similar expected return, however, does not lower the overall expected return for the diversified portfolio. This means that we can eliminate company-specific risk without the trade-off of lowering expected return, so that’s the one “free lunch” in finance.

Investors often use a combination of equity index funds, which reflect a weighted aggregation of the prices of a basket of stocks, to achieve the benefits of diversification. An index fund can represent a collection of companies of a certain size, like small-capitalization companies, or companies in a particular industry, like electric vehicle batteries or healthcare. Index funds can often be a cost-effective and efficient tool in constructing a diversified portfolio. Index funds, though, pose a potential pitfall in the quest for diversification.

The Potential Pitfall Posed by Index Funds

Depending on the index's composition and the price movement of underlying stocks, an index fund can become heavily overweight in exposure to just a few companies. This increases the chances that an index bears the idiosyncratic risk of those companies and loses the "free lunch" risk/return benefit of true diversification.

For example, the S&P 500 Index, which represents the 500 largest U.S. companies, is heavily concentrated in a few large tech firms. Apple, Microsoft, and Amazon together comprise nearly 15% of that index’s weighting, despite the fact that they are only three companies. If they perform exceptionally poorly (or exceptionally well), that company-specific performance would have an outsize impact on an S&P 500 index fund.

An Informed Approach to Index Funds

The takeaway for investors is to not assume that any given index fund provides sufficient diversification. Rather, be aware of dynamic index fund compositions and concentrations, and make appropriate allocations accordingly in order to benefit from finance’s one and only “free lunch.”

- Anthony Winkels is Managing Partner and Wealth Advisor at Fortis Wealth Management