Like many of us this winter, I am making the long trip back to my parents’ house for the holidays. I live in New York, and my parents live in California. Look around my mother's kitchen and you'll find a lesson in diversification that can school us on how we should be investing our money.
My mother has no fewer than four different types of chili powder, along with a flour for making chapati, another flour for making cakes, a flour we bought years ago for making a particularly delicate chiffon, all kinds of pudding and, inexplicably, two jars of sun-dried tomatoes. Her cabinets are full of ingredients to prepare for the arrival of me, my sister and our preferred meals.
It's not always easy to predict which sister will arrive first. Should mom buy ingredients for my favorite lunch of lemon rice, or my sister's preferred idli upma, made with semolina and chilis? Luckily for us, she buys ingredients for both.
What is diversification?
The economist Henry Markowitz famously called diversification the only "free lunch" in economics. I'm here to tell you that having lunch at my mother's is exactly what Markowitz was talking about.
"Diversification" refers to the practice of investing in multiple, maybe even competing, assets. Every investment asset has a certain level of risk and a certain return. Usually, these go in opposite directions — assets with high returns (like moonshot companies' stocks) also have high risks (which is why they're called moonshots).
If my mother just kept just lemons and rice on hand, and my sister came home first, my sister would be a little sad and so would my mother. But if my mother has both, then maybe she buys smaller quantities or needs a little extra cabinet space, but she's guaranteed that whoever arrives first will say, "Mom, this is the best!"
Markowitz and his co-author, Merton Miller, won the Nobel Prize for formalizing the intuition of my mother's kitchen with math: diversifying across assets, especially if they have nothing to do with each other, means you can have the same return while lowering your risk. They called it a "free lunch" because normally to get higher returns, you have to take on higher risk. But with diversification, you get the same or higher returns, and lower overall risk.
How do you diversify?
These days, the stock market seems almost obnoxiously high, driven almost entirely by tech firms promising profits from a forthcoming AI boom. The returns are obvious, but the risks are there, too. When a “frothy market” feels chaotic and risky and makes you anxious, Markowitz told us what to do: diversify.
The last time the stock market experienced a disastrous crash — during the Great Recession of 2008 — less risky, lower return assets went in the opposite direction. The dot-com bubble of the early 2000s was just like that, with non-tech firms less affected.
The emotional barrier with diversification is that when one asset type — like tech stocks — is doing so well, investing elsewhere can feel like missing out on a great party. It can even feel like throwing money away, as inevitably some assets do better than others. Diversification means you don't just pick winners — you pick losers, too, with the thought that they might be winners one day. But regret is kind of the point of diversification. Regret that you missed out on the party can just as easily be regret that you went down with the party cruise ship.
In practice, diversification looks like investing in many different asset types: not just the stock market, and not just the S&P 500 or your favorite index. It means investing in international stocks or in Treasury and municipal bonds, and keeping some cash in a high-yield savings account, too. It looks like not gaining as much when the market soars — like it did the week after the November election — but also like not losing as much when the market corrects — like it did the week before Christmas.
Because here’s the inevitable: Both my sister and I will make it home for Christmas. Both sets of ingredients will be used. Investing in just a few places in a market that seems too good to be true is like spending all your cash on a fancy restaurant: When expectations are high, there's more room for disappointment. In uncertain times, take a trip home to Mom's house for the only free lunch in economics.
