How Diversification Helps You Save Money

In an article reviewing apps that can help you save money, Forbes writer Katie Roof, noted that a great use of personal financial management software (specifically, the Personal Capital app) is to “look at your assets to see where there are opportunities for investment diversification.”

It’s a great insight – while diversification is a well-used investing tool, it can be overlooked as a way to save money. 

The Theory: "The Only Free Lunch In Investing"

Diversification is a relatively intuitive concept. We’ve all heard the axiom “don’t put all your eggs in one basket.” Its simplistic application to investing is as follows: if all your eggs (stocks) are in one basket and you drop it, you lose everything. However, if you have 10 eggs (stocks), each with its own basket and you drop one, you’ll still have nine eggs (stocks) left.

While diversification is not a new concept in investing, it was not until the 1950s that investors began to quantify its benefits.  In 1952, Harry Markowitz – then a 25-year old economist at the University of Chicago – wrote the seminal paper called Portfolio Selection.  The remarkable insights in this paper formed the basis for Modern Portfolio Theory, and ended up earning him the Nobel Prize in 1990.

A key insight of Modern Portfolio Theory is the classification of risk into two types: unsystemic risk and systemic risk.  Unsystemic risk, or diversifiable risk, is the risk that comes with owning a single stock that may decline on its own. For example, if there’s a management scandal at Company X, that is considered unsystemic risk. Systemic risk, or un-diversifiable risk, is the risk that the economy as a whole will experience a downturn.  A recent example of systemic risk is the subprime mortgage crisis, which sparked a worldwide decline in financial markets.

In his work, Markowitz showed that the unsystematic risk of a portfolio can be decreased through diversification.  In other words, while the return of a diversified portfolio will be equal to the average rates of return of the individual holdings, the risk (as measured by the standard deviation) of the portfolio will be less than the risk of the individual holdings.  That’s why diversification has been called the only free lunch in investing.

Your Portfolio: The Benefits Of Diversification

As you can imagine, by investing a number of different companies across asset classes and industries, you can substantially reduce risk and maximize your risk-adjusted returns. The math gets more complicated, but it turns out you can also solve for maximizing mean for a given level of variance – which is called an “efficient” portfolio.  The “efficient frontier” is then the set of investment portfolios that provide the greatest return for the risk you take.

So we can now return to our initial question: how does diversification help you to save money? By reducing the risk of potential loss.  If you invest in a portfolio on the efficient frontier, you can minimize risk while maximizing returns, and save money in the process.