In economics, there is a saying that there’s no such thing as a free lunch. This means that while you might not be paying for your lunch on any given day, it’s not truly free. Someone, somewhere is paying for that lunch. In the investment world though, they say diversification is deemed the only free lunch in investing. In today’s video, I’ll outline what diversification is, why it’s important, and how to go about diversifying your portfolio.

So what is diversification?

Diversification is not putting all your eggs in one basket. It’s spreading out your money across a variety of securities so that you’re not exposed to one risk. The opposite of diversification is piling everything into one single security. The most common example of this in my industry is the tale of Enron. Enron was an American energy, commodities, and service company. Fortune named Enron America’s Most Innovative Company for six years. But that all came crashing down when it was found out that they were cooking their books. This is an extremely sad story for some who had invested in what they knew, their employer. Their life savings, retirement fund, and career were all tied up in one company. When Enron failed, people were left jobless and penniless.

So what can people do to combat this risk? The key is to spread out your investments in a variety of securities. Instead of purchasing one stock, purchase 30, or in today’s age, thousands with the use of an ETF. This reduces the risk that one or more companies will fail and wipe out a large portion of your portfolio. As you add more securities to your portfolio you reduce specific company and industry risks within your portfolio. Eventually, you’ll only be exposed to systematic risks, the risks inherent in an entire stock market.

There are many facets of diversification that you should incorporate into your portfolio.

Include multiple securities: Not just investing in 1 or 2 stocks that you know and/or think will do really well, but adding many others to reduce the risk that if one stock does poorly your whole portfolio does poorly. Companies can go to zero, markets don’t. This is especially important when it comes to bonds. While the upside on other stocks in your portfolio can compensate for companies that go bankrupt, there is little upside on bonds. So if you hold 2 bonds and 1 company can’t pay you back, your other company won’t give you any more return than the yield to maturity when you bought it.

Diversify across the major asset classes: Depending on your goals and risk tolerance, include stocks and bonds that have different reactions to the changing economy and reduce the volatility of your portfolio.

Diversify across sectors: You’re not fully diversifying if instead of buying just TD, you’re buying RBC, Scotiabank, CIBC, and BMO too. These stocks are all within the same sector and so they have similar reactions to economic data. Exposure to different sectors will have different reactions to market conditions, like rising interest rates for example. If market conditions change, your portfolio won’t all decline at the same time.

Diversify Across Geographies: While the economy is becoming globalized, countries’ economies don’t all move in lock-step with each other. Investing outside of Canada and even the US lowers your risk.

The reason the above facets of diversification should be incorporated into your portfolio is a mathematical concept called correlation. Don’t cover your ears just yet. I won’t make you do any math,

I promise! Perfect Positive Correlation is when two assets move in lock-step together. When one goes up, the other goes up by the same amount. The same is true when one asset falls in value.

Perfect Negative Correlation occurs when one asset goes up, and the other goes down by the same amount. In the investment world, assets have a correlation in between these two. By adding non-correlated and negatively correlated assets into the mix, you reduce your portfolio risk. When your stocks are falling, your bonds might increase in value. A portfolio with the same expected return but with lower volatility will outperform. It also allows you to rebalance your portfolio, and reduces your desire to bail out of your portfolio because you can’t handle the huge losses.

Diversification is called the only free lunch because you reduce the risk within your portfolio by adding more non-correlated securities, without reducing your expected return. However, while you don’t give up the expected return, you do give up something. What you give up is the chance that you pick the next big stock that will hit it out of the park. With broad diversification, you’ll still be holding those winners, but they’ll be a small proportion of your portfolio and won’t make you an instant millionaire. Research shows that professional stock pickers aren’t very successful at beating the market when incorporating fees and taxes. So I’m personally a-okay knowing that I won’t hit it out of the park but my risk is vastly reduced, and I’m expected to earn the market return at a low cost.

The easiest way to achieve broad diversification is through Index mutual funds or ETF’s that hold large portions of the market in a single fund. I’ll outline these in more detail in a future video and how you can think about building a portfolio of these types of funds that’s appropriate for you.