Diversification … how many pieces to the pie?

First, what is the difference between diversification and asset allocation?

Diversification means the mathematical process to reduce risk through the use of many different types of assets.  Diversification: on Wikipedia.

Asset class is the definition of the types of assets that go into diversification formulas. Asset Class discussion on Investopedia.

Asset allocation is when risk versus reward are balanced according to the risk capacity, risk tolerance, time frame and goals of the investor. Asset Allocation on Wikipedia.

 

 

When it comes to the topic of diversification people have this idea that the more pieces (more investments) they have means they’re more diversified! Wrong!

By the discussions linked to above, what are more important are

1) Asset classes that are distinct and don’t overlap (you are not as diversified as you think if there is overlap) and

2) how they interact with each other where the different classes tend to do different things at different times.

So it is not necessarily how many pieces you have in your pie, but what makes up the ingredients of the pie pieces to begin with … the entire global economy makes up the entire pie. One could cut the pie into very tiny pieces; however those would be similar to other tiny pieces nearby (similar asset class). The pieces become clearer when one recognizes the few broad main asset classes and diversify accordingly working from the broader big picture on down using indexed mutual funds for defined asset classes.

In summary, the ingredients of each piece of your pie are the similar investment holdings with similar investment characteristics. Diversification comes when each piece of your pie is different from each of the other pie pieces with holdings that are dis-similar from each of the other pie pieces.

 

Related to diversification is the topic of Rebalancing.

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