Why the way most investors think about portfolio diversification is ‘deeply flawed’

Diversification has long been one of the bedrock principles of investing but the way most investors think about it is deeply flawed.

That’s according to Chris Carrano, vice president of Venn at Two Sigma, who has been telling InvestmentNews why “true diversification” is often misunderstood, and how a factor-based approach can help investors see what’s really driving their portfolios.

“The conventional understanding of diversification is spreading investments across stocks, bonds, real estate and other asset classes,” says Carrano. “But the problem is that this approach may provide a false sense of security.”

He says that even when portfolios appear diversified by asset class, they may still be heavily exposed to the same underlying economic forces.

“If a significant portion of your portfolio is sensitive to the same fundamental drivers of risk you might not really be diversified,” he says. “Hidden exposure to a factor might create unexpected impact across asset classes when that factor moves.”

Carrano warns that “a portfolio with real estate, bonds, equities and foreign currencies might seem diversified, but all of these asset classes are sensitive to movements in interest rates. When seemingly different assets move in lockstep following a shift in rates, that’s a telltale sign of a lack of true diversification.”

True diversification

True diversification, he argued, requires exposure to multiple independent drivers of risk, noting that this is why sophisticated investors such as pension funds, endowments, and sovereign wealth funds, are increasingly turning to factor-based analysis.

“A factor lens measures how assets respond to fundamental forces like economic growth, inflation, or credit stress, enabling investors to see beyond labels to understand their actual risk concentrations,” says Carrano. “Looking at portfolios through a factor lens reveals whether investors have genuine diversification or just a bunch of complexity disguised as it.”

One of the biggest misconceptions investors hold, he says, is that owning multiple assets or asset classes creates diversification, when in reality these are just labels that have little to do with fundamental drivers of risk and return.

Carrano illustrates this with an example from the bond market.

“The largest single driver of risk for the Bloomberg Global High Yield Index is not credit risk, but equity risk, contributing to roughly 40% of the overall risk in our model,” he says, adding that the same analysis can be applied to any portfolio with a return history. “Oftentimes, portfolios are heavily exposed to just a few key factors regardless of the number of holdings,” he says.

The illusion of diversification, Carrano warns, can be especially dangerous during times of market stress.

“As the number of assets and labels grows, investors are more likely to believe it is diversified and ‘safer’ from risk,” he says. “But they are more likely to be surprised when a few factors, such as economic growth or interest rates, explain the majority of its exposure, risk, and return.”

These risks tend to compound during economic crises.

“We often see distinct factors become more correlated for short periods, amplifying losses across what an investor previously believed was a well-diversified portfolio,” Carrano explains. “The portfolios best built to weather these economic storms are those with exposure to multiple independent risk factors.”

Complexity myth

Carrano also challenges the idea that adding complexity improves diversification.

“The idea that complexity leads to diversification is one of the biggest myths in investing,” he says. “A factor lens cuts through complexity to reveal what actually matters. It is possible to have a highly diversified portfolio without requiring hundreds of investments across multiple asset classes.”

He adds that once an investor begins to view their holdings through a factor lens, “the specific holdings are deemphasized for assessing diversification.”

Carrano says that “in theory, two portfolios with completely different assets and complexity levels, but identical factor profiles, would be expected to produce the same results and levels of diversification.”

And he concludes that ultimately, for investors, this realization can be liberating.

“No longer do they need to chase complexity to provide a veneer of protection,” he says. “Investors who are ready to look at diversification from a fresh perspective may be best positioned to limit diversification disappointment in times of market stress.”