Diversification

Why not putting all your eggs in one basket actually works

Any single company can go to zero. A whole market of companies essentially cannot. That asymmetry is the entire case for diversification: by owning many things whose fortunes do not move in lockstep, you shed the risks that come from any one of them without giving up the return the group delivers.

Economists like to say diversification is the closest thing investing has to a free lunch, and the phrase has earned its keep. Mixing holdings that do not rise and fall together tends to smooth the ride without a matching cut in long-run return: more return per unit of risk, which almost nothing else in investing offers for free. You are not paid extra for the risk of holding one stock instead of hundreds, because that risk is so easy to eliminate.

The three layers of diversification

Diversification works in layers, and each one removes a different kind of risk.

• Within an asset class. Owning hundreds of stocks instead of one means no single bankruptcy, scandal or missed quarter matters much. The same logic applies to bonds: many issuers instead of one.
• Across asset classes. Stocks and bonds respond to different forces, so pairing them softens the swings. A stock crash hurts a mixed portfolio far less than an all-stock one, which is the territory of asset allocation.
• Across geographies. Countries have their own booms, busts, currencies and political risks. Spreading across Canada, the US and international markets means no single economy decides your outcome.

The Canadian home bias problem

Canadians overwhelmingly invest in Canada, and it feels prudent: familiar companies, no currency conversion, a favourable tax treatment on Canadian dividends. But Canada is only a few percent of the world's stock markets, and the Canadian market itself is unusually concentrated in three sectors: banks, energy and materials. Whole industries that drive global growth, like technology and health care, are barely represented at home.

An all-Canadian portfolio therefore doubles down twice: on one small economy, and on one currency. If Canada has a rough decade, your job, your house and your portfolio all sink together. Global funds fix this in a single purchase, wrapping thousands of companies from dozens of countries into one holding. Keeping some home-market weight is reasonable; letting home be most of the portfolio is a concentration bet dressed up as caution.

What diversification does not do

Honesty requires this paragraph: diversification will not save you from a market-wide crash. In a genuine panic, correlations rise and almost everything falls together for a while; a globally diversified stock portfolio still dropped hard in 2008 and 2020. What diversification removes is the unrewarded risk of any single company, sector or country failing you. The market's own risk stays, and only time, a suitable bond allocation and your own patience deal with that.

There is also such a thing as fake diversification, sometimes called di-worse-ification. Owning 30 funds that all hold the same large companies is not diversification; it is one portfolio bought 30 times, with extra fees and paperwork. The measure of diversification is how different your holdings are, not how many lines appear on your statement. A single global fund can be more diversified than a dozen overlapping ones.

How index funds and ETFs made it cheap

A generation ago, real diversification meant buying dozens of individual stocks or paying a mutual fund manager handsomely to do it. Today an index fund or ETF delivers thousands of companies across the world for a fee close to zero, and a single asset-allocation fund adds bonds and automatic rebalancing on top. The free lunch used to require a full kitchen; now it comes prepackaged.