Diversification and asset allocation
Not putting all your eggs in one basket is investing's only "free lunch". How to diversify and why the mix between stocks and fixed income decides almost everything.
Diversifying means spreading your money across investments that don't move the same way, so one's bad moment doesn't ruin everything. It's said to be the closest thing to a "free lunch" in finance: it reduces risk without necessarily reducing expected return.
The dimensions of diversification
- Across companies: many instead of a few.
- Across sectors: technology, health care, consumer, financials, energy…
- Across countries and currencies: Mexico, the U.S., the rest of the world; pesos and dollars.
- Across asset types: stocks, fixed income, and for some people gold or real estate.
- Over time: investing little by little instead of all on one day.
Correlation
The key to diversifying is combining things with low correlation: that don't always rise and fall together. Two very similar tech companies are highly correlated; stocks and government bonds usually have a lower correlation, and in many crises high-quality bonds have risen while stocks fell (though not always: in 2022 both fell).
Asset allocation: the most important decision
Asset allocation is what percentage you put in each type of investment, especially between stocks and fixed income. That mix explains most of how your portfolio behaves: how much it rises, how much it falls and how well you sleep.
| Mix (stocks / fixed income) | Typical profile | What to expect |
|---|---|---|
| 20 / 80 | Conservative | Small drops, modest growth |
| 40 / 60 | Moderate | Balance between growth and stability |
| 60 / 40 | Balanced | Noticeable drops in crises, good long-term growth |
| 80 / 20 or more | Aggressive | Sharp drops in crises, more expected long-term growth |
There's no right mix for everyone. It depends on your time frame, capacity and tolerance for risk. A common idea is to hold more stocks the farther away the goal is and to shift toward fixed income as it approaches.
How many stocks you need to be diversified
With 20 or 30 stocks from different sectors, each company's specific risk drops a lot, but you're still exposed to what happens to those sectors and your country. A broad ETF gives you hundreds or thousands of companies in one purchase; that's why many people use ETFs as the core.
False diversification
Owning many instruments isn't always being diversified. Five tech ETFs, or an S&P 500 ETF plus a Nasdaq-100 ETF plus the same big tech stocks, can concentrate your money in the same companies. Check your real exposure: what you own directly plus what's inside your funds.
Home bias
Many people invest almost everything in their own country because they know it. Mexico is a small part of the world market; if your job and your home also depend on the Mexican economy, holding a part abroad can reduce your total risk.
Test what you learned
1. What do you seek by combining investments with low correlation?
- That they always rise and fall together
- That they don't always move the same way
- Paying lower fees
Show the answer
That they don't always move the same way. That way one's drop doesn't drag all of them down.
2. Which decision explains most of a portfolio's behavior?
- Which individual stock you buy
- The mix between stocks and fixed income
- The day of the week you buy
Show the answer
The mix between stocks and fixed income. Asset allocation defines how much it rises, falls and how stable it is.
3. You own an S&P 500 ETF and a Nasdaq-100 ETF. What can happen?
- You're perfectly diversified
- You repeat many of the same large companies
- They have nothing in common
Show the answer
You repeat many of the same large companies. There's overlap: the big tech companies are in both.
Track your progress in ARCO
With a free account you save the lessons you finish, your streak and your achievements, and answer the question of the day.
Everything in this section is educational: it explains how investing works, it doesn't tell you what to buy.