Does diversification reduce risk?

Some people have the misconception that diversification reduces risk. Strictly speaking, it doesn’t.

Diversification is systemically exposing our portfolio to more kinds of risk while simultaneously capping the negative impact from any one kind of risk. The latter is the goal; the former is an unavoidable side effect.

• Undiversified portfolio: Safe and well most of the time, but one occasional “bad event” can possibly take down the entire portfolio.
• Diversified portfolio: Frequently impacted by “bad events”, but survives most (if not all) of them.

Diversification does not reduce risk, but rather, it manages risk by intentionally spreading the bets. Diversification sacrifices extreme highs to avoid extreme lows. (See also: Diversification shields you from extremes.)

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This applies to diversifying across asset classes, e.g. holding equity, bonds, real estate, etc within a portfolio. This also applies to diversifying within an asset class, e.g. investing in equity from multiple countries instead of just one country, or investing in a diversified mutual fund instead of holding a few securities directly.

But don’t bring this up while advising beginners!

This “Diversification does not reduce risk” narrative is technically correct, but it’s annoyingly pedantic. Similar to claiming that mutual funds have no compounding. These narratives may be technically correct, but they both miss the point.

Practically speaking, many investors are better off investing early rather than investing late. Many investors are better off with a diversified portfolio than a concentrated portfolio. Citing these narratives—that compounding doesn’t really apply or diversification exposes you to more risk—to refute investment advice is more nuisance than it is helpful.