One of the most counterintuitive lessons in investing is that adding a riskier investment to a portfolio can sometimes make the overall portfolio less risky.
At first glance, that seems impossible. If one investment is more volatile than another, wouldn't adding it simply increase risk?
Not necessarily.
Modern Portfolio Theory teaches us that portfolio risk isn't determined solely by the risk of each individual holding. It's also determined by how those holdings behave relative to one another.
Market Downturns Are a "When," not an "If"
One thing investors can count on is that market downturns will happen.
Whether you define them as corrections, bear markets, recessions, or simply periods of significant volatility, declines are a normal part of investing. Historically, meaningful downturns have occurred every several years, although the timing, duration, and severity are never predictable.
The challenge is that we don't know exactly when the next downturn will arrive, how far which markets will fall, or which asset classes will struggle the most.
What we do know is that over long periods of time, different investments experience those downturns and recoveries differently. Stocks, bonds, real estate, international markets, alternatives, and other asset classes rarely move in perfect lockstep. Their periods of strength and weakness tend to occur at different times or at least at different levels of severity.
That's where real, thoughtful diversification becomes most valuable.
Correlation, Not Just Volatility
When investors think about risk, they often focus on volatility.
But Modern Portfolio Theory (MPT - Investopedia) places significant emphasis on another concept:
Correlation.
Correlation measures how closely investments move together.
- Highly correlated assets tend to rise and fall together.
- Low-correlation assets often move more independently.
- Some assets may even move in opposite directions during certain market environments.
Because of this, a portfolio's risk is not simply the average of its individual holdings' risks.
A more volatile asset may actually reduce overall portfolio risk IF it behaves differently from the investments already in the portfolio.
Building Resilience
Imagine a portfolio made entirely of investments that tend to react the same way to economic events.
Even if each investment appears relatively reasonable on its own, the portfolio may be vulnerable because all of its parts are exposed to similar risks.
Real diversification seeks to address that problem.
By combining investments with different return patterns, investors can potentially reduce the impact of any single market event or specific risk factor. When one area of the portfolio is struggling, another may be holding up better, recovering faster, or benefiting from a different set of economic conditions.
The goal isn't to eliminate risk. That's impossible.
The goal is to build a portfolio that can better withstand the downturns we know with a high degree of certainty will eventually occur.
The Bigger Takeaway
Successful investing isn't about predicting the next correction, recession, or bear market.
It's about acknowledging that those events are inevitable and positioning accordingly.
Because we can't know when the next downturn will arrive or what it will look like, one of the most effective tools available is diversification: thoughtfully combining investments that don't all respond the same way at the same time.
That's why a portfolio can sometimes become less risky by adding an investment that appears more risky on its own.
It's important not to hyperfocus on individual pieces of your portfolio and which has done "best" or "worst" recently'; it's about how the pieces work together.
This article is for educational purposes only and should not be considered investment advice. All investments involve risk, including the possible loss of principal. Diversification does not guarantee a profit or protect against loss in declining markets.
9056842.1 - Exp 08/2028