Demystifying Diversification

Wealth Beacon Team
May 28
3 min read

Updated: Aug 1

Introduction

We often hear financial planners and wealth managers throw around terms like risk-adjusted returns and diversification. These terms might sound complex or overly academic, but they carry immense practical relevance. A common question many investors ask is: Why not just put all my money into the asset class that yields the highest return?

This question is entirely valid - and it’s precisely what we’ll explore and demystify in this blog. The answer lies in understanding not just the magnitude of returns, but also how those returns are earned.

A symbolic scene showing two roads leading to a city skyline—one smooth and paved, the other rough and dirt-covered. Two cars and pedestrians face a choice between the two paths, representing investment decisions and risk.

Risk-Adjusted Returns: It’s Not Just About Speed, But the Ride

Imagine two roads leading to the same destination, City A. One is a well-paved highway that gets you there in four hours. The other is a bumpy dirt road that takes 3.5 hours. If you’re traveling with your family, would you trade comfort and safety for a slightly quicker arrival?

This analogy mirrors the idea of risk-adjusted returns. In the world of investing, returns aren’t the only thing that matters - the journey to earning them matters just as much. A smoother path may make it easier to stay the course, while a bumpier road can lead to emotional decisions that derail long-term plans.

Risk-adjusted return metrics help investors evaluate the quality of returns. Two widely used measures are:

Sharpe Ratio: Evaluates return per unit of total risk.
Information Ratio: Measures excess return over a benchmark relative to the volatility of that excess return.

These metrics divide the “excess return” by a measure of volatility (or bumpiness). If you're curious to explore the formulas and nuances, you can read more on Wikipedia.

Diversification: The Only Free Lunch in Investing

Harry Markowitz, the Nobel Laureate behind Modern Portfolio Theory (MPT), famously said:

“Diversification is the only free lunch in investing.”

What does that mean?

Diversification involves spreading your investments across different asset classes - Equity, Gold, Debt, Real Estate, Foreign Equity, etc. The idea is simple: different asset classes behave differently under various market conditions. When one zigs, another may zag.

The mathematical foundation of diversification, developed through MPT shows that a well-diversified portfolio often delivers better risk-adjusted returns than a concentrated one. You may not always get the maximum return, but you’ll likely enjoy a smoother, more consistent ride.

An Example: Nifty500 vs. Gold vs. a Diversified Portfolio

Let’s take a look at actual data between Jan 3, 2005 to May 23, 2025, comparing three strategies:

100% NIFTY500
100% Gold
50% NIFTY500 + 50% Gold

Here’s a chart comparing the annualized return (XIRR) and standard deviation (a measure of risk):

Graph comparing Nifty 500, gold, and portfolio returns from 2005 to 2025. Yellow, blue, and purple lines; values increase over time. — *Note: These are illustrative figures based on historical trends.*

Line graph titled "Maximum Drawdown" shows Nifty 500 (blue), Gold (yellow), and portfolio (purple) trends over time with fluctuating data. — *Note: These are illustrative figures based on historical trends.*

The 50/50 portfolio didn’t generate the highest return, but it provided a smoother ride with significantly lower risk. That’s diversification in action—improving the journey without dramatically sacrificing the destination.

“But I Want the Highest Returns!” - Should I Still Diversify?

Yes, if you want the absolute highest potential return, you might be tempted to go all-in on equities. That is, if this is a weekend adventure, you may want to take the dirt road for the thrill. But consider:

Would your car break down mid-journey? In investing terms, that’s panic-selling during a market crash. In March 2020, equity markets dropped over 40% in a few weeks. Many investors exited in fear, locking in losses and missing the recovery.

What if the dirt road has a crater? This represents unknown future risks. Investing is a probabilistic game. There are no guarantees. Going all-in on one asset class assumes we can predict the future with certainty. Spoiler alert: we can’t.

Diversification is also a form of humility. It acknowledges that markets are unpredictable and that placing all our bets on a single horse is not just risky - it’s reckless. A diversified approach increases the probability of meeting your long-term financial goals.

Summary: Why Diversify?

Risk-adjusted returns help evaluate not just how much you earn, but how bumpy the path is.
Diversification smoothens the investment journey by balancing risk across asset classes.
Historical data shows that mixing assets can deliver more stable performance.
Even if you're chasing the highest returns, diversification helps you stay in the game, especially during rough markets.
It’s not about picking the fastest route, it’s about reaching your destination reliably.

In investing, staying the course is half the battle and diversification is your friend. Your financial planner can help you create a well diversified portfolio according to your goals and risk tolerance.