By understanding how a portfolio, rather than an individual security, generates wealth, we can see that spreading financial risk across asset classes actually helps to sustainably grow your wealth by compounding your earnings. At first glance however, it does seem a bit contradictory: How could holding on to many securities that potentially may not perform well on the aggregate during a bull market as opposed to a few good winning stocks, strengthen your investment portfolio? The beginner investor might ask themselves, wouldn’t it be better to have only those few winning stocks, rather than keep their money in investment vehicles that aren’t performing the way they hoped?
To wrap your head around this, one must understand investing in terms of portfolio performance, instead of individual security performance. Unfortunately, the overriding image most have of investing is of “beating the market.” It is a strategy of buying low, and selling high. In essence, this approach makes investing seem like a high-stakes game of speculating. The reality however, is that trying to time the market rarely works. In fact, for most investors, the opposite happens: They buy high and sell low.
One thing to consider when trying to understand diversification, are the ups and downs of the market. When the market turns sour, the value of your investment portfolio will significantly decrease if all your assets are moving in tandem with one another. When investors don’t diversify, their assets are much more correlated with one another. That means your portfolio as a whole is more susceptible to changing market conditions. Thus, after a bear market, you are rebuilding your portfolio to previous levels, rather than having compounded a lower amount of earnings if you had diversified.
Fortunately, slow growth and compounding returns also allow our investments to consistently grow, with the added benefit of not sustaining huge losses. What are the benefits then of trying to reap huge gains if they are so easily wiped-out? This is why portfolio diversification is vital to cultivating your wealth.
In general, diversification works because speculating rarely does. Regardless of your risk style, wealth can’t be built if you have to continually rebuild it.