Diversification is the only free lunch. Usually earning a higher return requires taking more risk, or taking less risk requires earning a lower return. You can hedge your risk by buying insurance via options, but that requires paying expensive insurance premiums. Diversification is the only way to reduce your risk without any cost. We strongly recommend all investors diversify their portfolio to take advantage of this fact. However, too much diversification will cause your returns to approach market returns. If you achieve maximum diversification, by definition you own every stock in the market. In reality, you can be well diversified with just 10-15 stocks.

Not all risk is diversifiable. You can diversify idiosyncratic (stock specific) risk, industry risk, and thematic risk, but you cannot diversify market risk. You can allocate more money to other asset classes to reduce your exposure to equities, but the correlations between asset classes can (and often do) change. For example, historically bonds were inversely correlated with equites. However, that relationship existed in a period of time when inflation was low. Bonds have underperformed just as much as equities now that inflation has re-emerged. When there is a regime shift like this you can see that other asset classes don’t diversify your market risk that much. We recommend maintaining full exposure to equities in order to minimize your long-term financial risk, and ignoring market volatility. When you need to withdrawal money from your brokerage account to make a major purchase you should begin allocating money to something less volatile like bonds.

Passive indexes are not diversified. Passive indexes like the S&P 500 or Nasdaq 100 are weighted by market capitalization. This means the largest stocks comprise a greater percentage of the index. For example, the top 10 stocks in the S&P 500 account for 50% of the index. The majority of the index’s returns are driven by this handful of stocks, with little contribution from smaller stocks. You are more exposed to the idiosyncratic risk of these 10 companies than the other 490 stocks in the index. Given that the top 10 stocks are mostly technology companies, you are not diversified thematically either. Most technology stocks are driven by the AI theme. If the AI theme unravels then your entire portfolio will lose value.