“Don’t put all your eggs in one basket.”

Diversification refers to the practice of spreading investments across various asset classes like stocks, real estate, bonds, deposits, gold, and commodities to manage risk by reducing exposure to any single asset or risk.

Advantages

By investing in a diverse range of assets, investors can mitigate risk. A well-diversified portfolio can offset individual risks, minimizing unsystematic risk (idiosyncratic risk) to nearly zero, leaving only systematic market risk.

Diversification can be categorized by country, industry, asset type, and company. While some investment legends advocate for concentrated investments to achieve high returns, they rely on thorough analysis and extensive information networks. Without such resources, individual investors are likely to fail without diversification.

One of the main reasons individual investors fail in stock investments is their neglect of diversification. According to the Korea Securities Depository and Samsung Securities, many individual investors engage in high-stakes, all-in investments on one or two stocks. Statistics show that 44% of investors hold only one stock, 20% hold two stocks, and 11% hold three stocks, while almost none hold the 20 or more stocks recommended to eliminate idiosyncratic risk.

If a future inflationary or declining market is certain, shifting entirely to tangible assets like gold or safe assets like bonds would be ideal, but predicting such events is nearly impossible. Therefore, spreading investments across various asset classes from the start, though it may slightly reduce returns, significantly decreases overall volatility. For more insights, consider Ray Dalio’s All Weather Portfolio and Mark Faber’s asset allocation strategies.

For individual investors, the easiest way to diversify is by investing in index funds or ETFs that track market indices. Additionally, holding some bonds, US dollars, or inverse funds as a hedge against market downturns can further disperse risk, even if it slightly reduces returns in a rising market.

Principles

Diversification is often seen as a way to reduce risk, but there’s another perspective. Consider a market where prices have a 50% chance of halving and a 50% chance of doubling, with long-term returns converging to the initial value. By maintaining 50% in the market and 50% in cash, and rebalancing to this ratio as values change, an investor can achieve positive returns through rebalancing.

For example, starting with 10 million USD split evenly between the market and cash, if the market value halves to 2.5 million USD, transferring 1.25 million USD from cash to the market would rebalance the assets to 3.75 million USD each. If the market then doubles, the market value becomes 7.5 million USD, and rebalancing again to equal amounts results in a total asset value of 11.25 million USD. While a static investment would yield no profit, rebalancing gains 1.25 million USD.

Maximizing this effect requires assets that move inversely to each other, ideally managed through periodic rebalancing, recommended annually or as needed.

Disadvantages and Considerations

Naturally, diversified investments yield lower returns compared to successful concentrated investments. The primary goal of diversification is to avoid or minimize losses, rather than maximizing profits. If profit is the sole objective, riding the success of speculative stocks or meme stocks might yield higher returns, though the success rate is very low.

Moreover, simply spreading investments across various stocks without consideration isn’t true diversification. Effective diversification requires investing in assets or stocks that move inversely (e.g., physical stocks and inverse futures, Korean-listed stocks and the US dollar). Conversely, distributing funds across similar stocks in the same industry can amplify risks if the industry falters.

For individual investors, it’s challenging to diversify effectively with individual stocks. Instead, utilizing ETFs that track indices, along with bonds and commodities, and adopting a systematic investment approach, can provide sufficient diversification.

By understanding and implementing these principles of diversification, investors can create more resilient portfolios that weather market fluctuations more effectively.