Variety

Variety is an essential concept within financial portfolio theory, referring to the practice of combining various assets within an investment portfolio to mitigate specific risks. This strategy aims to reduce the impact of any single investment's poor performance on the overall portfolio by ensuring that different assets react differently to market events. By spreading investments across a range of securities, industries, and geographies, investors seek to achieve a more stable and predictable return profile over time. Variety, in this context, is fundamental to managing investment risk and is often synonymous with diversification.³⁸, ³⁹

History and Origin

The intuitive idea behind variety in investing—not putting all eggs in one basket—has ancient roots, with evidence of risk-spreading practices dating back 4,000 years to merchants in Mesopotamia. How³⁷ever, the scientific and mathematical underpinning of this concept in finance emerged much later. The seminal work is attributed to economist Harry Markowitz, who published his paper "Portfolio Selection" in The Journal of Finance in 1952. Mar³⁵, ³⁶kowitz's paper laid the groundwork for what is now known as Modern Portfolio Theory (MPT), which mathematically demonstrated how combining assets could optimize the balance between risk and return. His³³, ³⁴ contribution revolutionized investment strategy by providing a framework for portfolio construction that accounts for the correlation between assets, earning him a Nobel Memorial Prize in Economic Sciences in 1990.

##²⁹, ³⁰, ³¹, ³² Key Takeaways

• Variety, often termed diversification, is a core principle in investment strategy aimed at mitigating risk.
• ²⁸ It involves spreading investments across different asset classes, industries, and geographical regions.
• ²⁶, ²⁷ The primary goal of variety is to reduce unsystematic risk, which is specific to individual assets or industries.
• While variety can reduce overall portfolio volatility, it does not eliminate systemic (market) risk.
• ²⁵ Effective variety seeks to optimize risk-adjusted returns rather than maximizing absolute returns.

Interpreting the Variety

Interpreting the effectiveness of variety in a portfolio involves assessing how well the combination of assets contributes to achieving desired financial outcomes relative to the level of risk tolerance. A truly varied portfolio aims for assets that do not move in perfect lockstep with one another, ideally having low or even negative correlation. This allows the strong performance of some assets to potentially offset the weaker performance of others, thereby smoothing overall portfolio returns. Investors often look at metrics such as the portfolio's standard deviation of returns to gauge its overall volatility, with lower standard deviations generally indicating a more effective application of variety for a given expected return. The ultimate interpretation hinges on whether the portfolio effectively minimizes unsystematic risk while achieving an acceptable return for the investor's risk appetite.

Hypothetical Example

Consider an investor, Sarah, who has $100,000 to invest. Instead of putting all her money into a single technology stock, which could expose her to significant company-specific risk, she decides to apply the principle of variety.

Sarah allocates her $100,000 across different asset classes and sectors:

• $30,000 in a broad market index fund (equities)
• $25,000 in a bond fund (fixed income)
• $20,000 in a real estate investment trust (REIT)
• $15,000 in an international equity fund
• $10,000 in a commodities ETF

In a hypothetical scenario where the technology sector experiences a downturn, the single technology stock Sarah initially considered might drop significantly. However, because her portfolio exhibits variety, losses in her equity holdings might be mitigated by stable returns from her bond fund, potential gains from her real estate holdings, or positive performance from international markets or commodities. This spread of investments reduces the impact of any single asset's poor performance on her overall wealth, illustrating the practical benefit of a varied investment strategy.

Practical Applications

The principle of variety is broadly applied across various facets of finance to manage and mitigate risk. In individual investing, it guides individuals to spread their capital across a mix of stocks, bonds, mutual funds, and other securities. This can involve diversifying by industry, geography, company size, and investment style. For²⁴ mutual funds and exchange-traded funds (ETFs), variety is often a cornerstone of their design, with many funds inherently diversified across numerous underlying assets. For instance, the Investment Company Act of 1940 outlines specific rules for funds to be classified as "diversified," generally requiring that at least 75% of a fund's total assets be invested in securities, with limitations on how much can be invested in any single issuer.

Wi²⁰, ²¹, ²², ²³thin institutional portfolio management, variety is crucial for large endowments, pension funds, and sovereign wealth funds. These entities employ sophisticated asset allocation strategies to ensure their vast holdings are sufficiently varied across global markets, private equity, hedge funds, real assets, and other alternative investments to protect against systemic shocks and optimize long-term return for their extensive liabilities. Academically, numerous studies confirm the benefits of international portfolio variety in reducing investment risk for investors.

##¹⁸, ¹⁹ Limitations and Criticisms

While variety is widely touted as a fundamental investment principle, it is not without limitations. One primary criticism is that it primarily mitigates unsystematic, or idiosyncratic, risk—the risk specific to a company or industry. However, it cannot eliminate systemic or market risk, which affects the entire market, such as widespread economic downturns or global crises. During periods of severe market stress, correlations between different asset classes can increase, meaning that assets that typically move independently may fall in unison, diminishing the protective benefits of variety.

Anot¹⁶, ¹⁷her drawback is the potential for "over-diversification," where spreading investments too broadly can dilute potential higher returns from specific, well-performing assets or sectors. This ¹⁵can lead to a portfolio that simply mirrors the overall market, potentially limiting outperformance and sometimes increasing complexity and costs without proportional benefits. Criti¹³, ¹⁴cs of Modern Portfolio Theory, which champions variety, also point out its reliance on historical data to predict future returns and volatility, and its assumption of rational investor behavior, which may not hold true in real-world scenarios. Moreo⁸, ⁹, ¹⁰, ¹¹, ¹²ver, implementing a truly varied portfolio can be cumbersome to manage and may involve increased transaction costs or fees.

V⁷ariety vs. Concentration

Variety and concentration represent opposing approaches in portfolio management. Variety, or diversification, involves spreading investments across a multitude of distinct assets, sectors, and geographies with the goal of minimizing the impact of any single investment's poor performance on the overall return. The underlying philosophy is to reduce unsystematic risk by not putting all capital into one "basket."

Conversely, concentration involves allocating a significant portion of a portfolio to a small number of assets, or even a single one. This approach is typically undertaken by investors who have high conviction in the potential of specific investments or sectors. While concentration offers the potential for higher returns if those selected investments perform exceptionally well, it also exposes the portfolio to a much greater level of unsystematic risk. A concentrated portfolio is more vulnerable to adverse events affecting a specific company or industry, as there are fewer other assets to offset potential losses.

FAQs

What is the primary benefit of incorporating variety into an investment portfolio?

The primary benefit of incorporating variety is to reduce unsystematic risk, which is the risk specific to a particular asset or company. By spreading investments across different types of assets, industries, and regions, the negative performance of one investment can be offset by the positive performance of others, leading to more stable overall portfolio returns.

⁶Does variety guarantee returns or prevent losses?

No, variety does not guarantee returns or prevent losses. While it is a powerful tool for managing and reducing certain types of risk, it cannot eliminate systemic (market) risk, which affects all investments. During broad market downturns or market cycles, even a highly varied portfolio may experience losses.

⁴, ⁵How much variety is enough for a portfolio?

There's no single answer for "how much" variety is enough, as it depends on an individual investor's goals, risk tolerance, and investment horizon. However, academic research suggests that the majority of the benefits of variety in reducing unsystematic risk can often be achieved with a relatively modest number of well-chosen assets across different asset classes. Beyond a certain point, adding more assets may lead to "over-diversification," where the additional benefits of risk reduction become negligible, and management complexity or costs may increase.

², ³Is variety only about investing in different stocks?

No, variety extends beyond simply owning many different stocks. A comprehensive approach to variety involves investing across various asset classes (such as stocks, bonds, real estate, and commodities), different industries, companies of various sizes, and different geographical regions (domestic and international). It can also involve diversifying by investment strategy, such as blending growth and value investments.

¹Can variety be achieved with just one type of investment vehicle, like a mutual fund?

Yes, many mutual funds and exchange-traded funds (ETFs) are designed to provide inherent variety by holding a basket of many different securities, often across various industries or asset classes. Investing in such a fund can be an effective way for an investor to achieve significant variety without having to select and manage individual securities themselves. However, it is still advisable to assess the underlying holdings of any fund to ensure it aligns with overall portfolio variety goals.