Let’s say you have your entire 401(k) sitting in a money market account. You assume it’s safe. Safe from market volatility, maybe. But you’re losing money to inflation every single day.

This is the diversification paradox. Any investor will tell you diversification is important, yet we often see portfolios that are anything but diversified — concentrated in single companies, loaded up on last year’s winners, or spread across multiple advisors buying the exact same investments. 

In this blog we’ll break down what diversification really means and how to make it work for your financial future.

Don’t Put All Your Eggs in One Basket: Types of Diversification

Most people consider their portfolio to be diversified because they own more than one stock. But true diversification includes the following.

Company Diversification: Think Thousands, Not Dozens

When we talk about company diversification, we’re talking about owning enough individual companies to spread your risk. Many people think having five or 10 or even 30 different stocks is enough — in reality, you need thousands of companies in your portfolio.

Why so many? Because even with 30 companies spread across different industries, you’re still exposed to the risk that any individual could fail completely. A company can look great on paper, until suddenly it doesn’t.

Sector and Geographic Diversification: Spreading Beyond Your Backyard

Sector diversification means spreading your investments across different industries: technology, healthcare, energy, financial services, consumer goods, and more. Remember the tech bubble? Investors thought they were diversified because they owned multiple tech companies, but when the NASDAQ lost about 70% of its value in 2000-2001, those “diversified” portfolios got crushed together.

Geographic diversification extends this concept globally. US companies don’t always behave the same way as international companies. When US markets struggle, international markets might thrive, and vice versa.

Asset Class Diversification: Growth and Preservation Working Together

This is about mixing stocks and bonds: stocks for growth and bonds to preserve some of those earnings you’ve made over the years. Your portfolio needs to keep working for you, because retirement isn’t a cliff event where you suddenly stop investing.

The key is understanding that all these elements work together to create true diversification, owning different types of investments that behave independently from each other.

Why Diversification Works

Diversification isn’t just a nice-to-have investment principle — it’s backed by decades of market data. But understanding why it works can help you stick with the strategy when parts of your portfolio inevitably underperform.

  • Reduce risk without eliminating it: Diversification won’t eliminate risk entirely; you’ll still experience market ups and downs. But it will help to reduce risk by spreading it out, while maintaining your return potential.
  • The whole is greater than the sum of its parts: While the total return of a portfolio is simply the weighted average of its components, the risk is not. This is because of correlation: how investments move in relation to each other.
  • There’s stability in numbers: Investing in multiple stocks rather than a single stock is better because the outcome of multiple events involves far more factors than the outcome of one event.
  • Playing the odds in your favor: Diversification pulls you toward the average and eliminates the chance you’ll be an outlier on either favorable or unfavorable extremes, reducing uncertainty and therefore reducing risk.

Common Mistakes that Kill Diversification

Even investors who understand diversification can make critical mistakes that undermine their strategy. Here are the three most common pitfalls.

#1: Multiple Advisors

“I’m diversified because I have money with three different advisors.” We hear this all the time, and it’s one of the most dangerous misconceptions in investing. Having money invested through different institutions doesn’t make you diversified if they’re all putting it in S&P funds. You’re no more diversified than if you had all your money in one spot; you just have more statements to track.

Even worse, when advisors don’t coordinate, you can end up with overlapping investments or conflicting strategies. One advisor might buy you Shell stock while another loads you up on Exxon Mobil. Now you’re doubling down on oil exposure without realizing it, making you less diversified than if you’d worked with a single advisor.

The real danger? Your advisors might get different messages from you about your risk tolerance and goals. One might invest you aggressively while another takes a conservative approach, creating a portfolio that doesn’t serve any clear purpose.

#2: Chasing Last Year’s Winners

Let’s say you review your portfolio and see that your European investments returned 4% while your South American holdings shot up 80% — your immediate thought may be to put everything in South America.

This is called chasing returns, and it’s one of the fastest ways to destroy wealth. You’re looking in the rearview mirror and using that information to make future predictions. But as every good investment disclaimer reminds us: Past performance does not guarantee future results.

We have charts going back to 1970 that highlight this phenomenon. The data shows that there’s no discernible pattern from year to year; you can’t predict which asset classes will lead or lag in any given year.

When you chase last year’s winner, you’re also buying high. The “losers” from last year help you buy low, and when they inevitably bounce back, that’s where your greatest growth opportunity comes from. 

As Premier Principal and Advisor Jeremy Sorci says, the goal with long-term investing is “winning with base hits, not home runs.”

#3: Concentration Risk — A Lesson from Enron

The most painful lesson in diversification came from Enron employees in 2001. The average employee’s 401(k) was 60% Enron stock. Not only did their jobs depend on one company’s success, but their entire financial future did too. When Enron collapsed, employees were doubly devastated: They lost their jobs and their retirement savings at the same time.

This isn’t just about company stock, though. Any time you have too much riding on a single investment, you’re exposed to what we call “uncompensated risk.” You’re taking extra risk without getting paid for it.

“If you weren’t diversified and all your money was in one investment when disaster struck, you would see your investment get crushed,” Jeremy says. “But if that investment was just a small slice of a diversified portfolio? It could barely be a blip on your financial radar.”

Here’s the harsh reality: Thousands of individual companies have suffered permanent losses; some going all the way to zero. But there has never been a permanent drop in the overall US stock market. That’s the difference between company-specific risk and market risk.

Choose Investment Vehicles Wisely

Mutual Funds and ETFs

Unless you have significant wealth, building true diversification through individual stocks is often impractical. You’d need enough money to buy meaningful positions in thousands of companies across multiple sectors and countries.

Mutual funds and ETFs solve this problem by giving you instant diversification. Most 401(k) plans don’t even give you the option of buying individual companies — they want to force diversification because plan trustees understand the liability of concentration risk.

Index Funds vs. Actively Managed Funds

The diversification advantage of index funds becomes clear when you compare their holdings to actively managed funds. An S&P 500 index fund automatically gives you exposure to 500 companies, while a total market fund provides exposure to thousands of holdings across the entire market.

Watch the Costs

Diversification should also help optimize your costs. According to the Investment Company Institute, the average expense ratio for actively managed equity mutual funds was 0.66% in 2022, while index equity mutual funds averaged just 0.05% — more than 13 times lower. Those cost differences compound significantly over time.

The Discipline of Rebalancing

Here’s where diversification gets counterintuitive. If you’ve chosen your asset classes properly, they won’t all grow at the same rate each year. That’s actually the point — you want them to behave differently. 

But this creates a challenge. Suppose US large growth returns 15% while small value drops 10% in the first year. Your allocation is now out of whack. US large growth is over weighted, and small value is underweighted.

Rebalancing means selling winners and buying losers. This goes against human nature but is essential for maintaining your strategy.

Think of rebalancing as the only market-timing system that actually works. You’re systematically buying low and selling high by maintaining your target allocations. Without periodic rebalancing, your portfolio becomes overly concentrated in whatever performed best recently — exactly the opposite of what you want.

Your Financial Peace of Mind

We can’t predict the next Enron, which sectors will outperform, or when markets will decline. But we can build portfolios that don’t require us to be fortune tellers. 

True diversification across thousands of companies, multiple sectors, different countries, and various asset classes protects you against the unknown. It won’t eliminate risk, but it helps ensure no single event can derail your financial future.

The best diversification strategy is one you’ll actually stick with. The advisors at Premier Financial Group have the expertise and discipline to help you navigate and manage a truly balanced portfolio tailored to your goals while keeping you focused on long-term success.

Ready to review your strategy? Contact Premier today. Let’s work together to make sure your finances are positioned for whatever the future may bring.