If asked to list the desirable properties for an investment portfolio, most investors would place diversification and cost at the top of the list--likely in that order. While the word “cost” can apply to many things, such as portfolio management fees, transaction costs, or even liquidity, it remains relatively unambiguous. Diversification, on the other hand, is less well understood. What investors really want is efficiency, the concept that encompasses both cost and diversification.

There’s really no universally accepted definition of portfolio diversification. Broadly it refers to mixing different types of securities together that respond differently to the same stimulus. Because of this, they rise and fall in value at different times and this, in turn, prevents the portfolio from going south in the instance of one or two bad events. On the other hand, it will prevent the portfolio from going through the roof when terrific events occur. The operative concept is that investors place more weight on bad events, like a loss of $1,000, than on good events like a gain of the same amount. This is the concept of “risk aversion” and it is what makes risk in an investment setting different from risk elsewhere.

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