The Virtues of Proper Portfolio Diversification

Talk about portfolio diversification often elicits a shrug and a yawn, if not deep skepticism.

I know this because our office is spitting distance from Amazon’s urban campus, and lately, we’ve had an uptick in relatively young investors from Amazon and other companies coming to us for help with financial planning. As you might imagine, many discussions revolve around portfolio diversification and why you don’t want to have half or two-thirds of your net worth wrapped up in one or two large technology stocks.

The chat about diversification often lands with a thud for those who have watched their Amazon investment zoom up over 60 percent in the past year. Or for Seattle real estate investors, whose property values rose by 17 percent in the same timeframe.

But the fact is, when you have a massive allocation to a single equity or asset—or even a handful of positions—you concentrate your company risk. That risk exposure can work out fantastically, but if the company’s fundamentals change or investor sentiment sours, it can also trigger a death spiral in your portfolio.

Many investors delude themselves into thinking that the short-term past is prologue, but those of us old enough to remember 1987, 2000, 2007, or the Enron meltdown know that past performance doesn’t necessarily repeat itself in the future. That’s why prudent investors trade company risk for market risk by buying inexpensive mutual funds or ETFs, which spread company risk over hundreds of equities rather than cornering you into a handful of concentrated positions.

Proper asset diversification goes beyond that. Stocks in your portfolio should include a mix of equity types and sizes with varying geographical exposure. Bonds and other fixed investment holdings should be equally diversified. Having the right mix of assets can really help to dampen the volatility of your portfolio.

Now, it’s true that Bill Gates and Paul Allen did not become billionaires from riding a portfolio of diversified assets. But we should stop kidding ourselves—the vast majority of us are not going to become wealthy beyond our wildest dreams by betting the farm on a single stock or a few positions. Most of us can, however, become financially independent by growing our wealth slowly through long-term, systematic savings allocated into diversified assets. Sure, it’s not as sexy as boasting about your Netflix or Amazon stock at cocktail parties, but most of the time tortoise really does win the race in the long run.

To understand why, check out this short Bloomberg article about GE employees who loaded up on company stock—and learned the importance of portfolio diversification a bit too late.