Diversification is often referred to as the only free lunch in finance, primarily because of its ability to reduce risks without reducing expected returns. Simply put, it can be defined as the spreading out of investments to reduce unnecessary risks.
The graph below illustrates a very simple example of how adding a riskier, less correlated asset to a portfolio can actually reduce volatility while not hindering expected returns. Even though Japan has historically been a more volatile asset class than the S&P 500, combining the two actually reduced risk and the total number of negative quarters. In this case, it actually increased return as well.* To name a few, bankruptcy, sector, and country risks can all be significantly reduced and sometimes eliminated with proper diversification.
Source: Dimensional Fund Advisors. Quarterly data: 1970-2008, rebalanced quarterly. The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright MSCI 2008, all rights reserved. * Results represent past performance and do not predict future performance.
Sector risk is commonly ignored in the investment industry, and for no good reason. For instance, in 2008, the stock market was highly concentrated in the financial sector (e.g. over 20% of the market), just before the worst financial crisis since the Great Depression. Similarly, as the 2000 - 2002 technology boom went bust, the market was overweighted, of course, in technology. In both examples, such sector over-allocations cost individual investors significant volatility and unnecessary losses, and ultimately delayed the retirements of over 40 million Americans.
Extreme over-allocations in certain sectors occur frequently, and can expose investors to a large amount of unnecessary risk. We mitigate this risk by utilizing advanced diversification strategies (without using futile market timing tactics) that help to balance out over-weighted sectors, as well as over-weighted countries, companies, etc.