Diversification

Diversification reduces risk without sacrificing return. Discover how to achieve it with index funds and which metrics Index Balance uses to measure it.

Definition

Diversification is the strategy of distributing investments across multiple assets, sectors, geographies, or asset classes to reduce the total portfolio risk without proportionally sacrificing expected return. The underlying principle is that when some assets fall, others may hold steady or rise, smoothing out overall fluctuations.

For index fund investors, diversification is almost automatic: a single MSCI World fund already contains ~1,400 companies from 23 countries. The real question is whether there is diversification across different asset classes: only equities or also bonds? Only developed markets or also emerging markets?

Diversification has a limit: systematic risk (global market risk) cannot be eliminated by adding more diversification within equities. Reducing it requires adding assets with low correlation, such as high-quality bonds or real assets.

Practical example

A portfolio with a single MSCI World fund holds ~1,400 companies but has high internal correlation because they are all global equities. Adding 20% in bonds can reduce portfolio volatility from ~16% to ~12% annually, sacrificing only 0.5-1% of expected long-term average return.