A lot of online blogs and investing material suggest that investing in a single index is not diversified enough to avoid some types of market risk.
So the question then is, what does a well diversified self-managed investment portfolio look like? This assumes we're not reducing the overall level of risk (and expected long-term returns) of the portfolio.
"Diversified" is relative.
Alfred has all his money in Apple. He's done very well over the last 10 years, but I think most investors would say that he's taking an incredible risk by putting everything on one stock.
Betty has stock in Apple, Microsoft, and Google. Compared to Alfred, she is diversified.
Charlie looks at Betty and realizes that she is only investing in one particular industry. All the companies in an individual industry can have a downturn together, so he invests everything in an S&P 500 index fund.
David looks at Charlie and notes that he's got everything in large, high-capitalization companies. Small-cap stocks are often where the growth happens, so he invests in a total stock market fund.
Evelyn realizes that David has all his money tied up in one country, the United States. What about the rest of the world? She invests in a global fund.
Frank really likes Evelyn's broad approach to equities, but he knows that some portion of fixed-income assets (e.g. cash deposits, bonds) can reduce portfolio volatility—and may even enhance returns through periodic rebalancing. He does what Evelyn does, but also allocates some percentage of his portfolio to fixed income, and intends to maintain his target allocations.
Being diversified enough depends on your individual goals and investing philosophy. There are some who would say that it is wrong to put all of your money in one fund, no matter what it is. Others would say that a sufficiently broad index fund is inherently diversified as-is.
When you invest in a single index/security, you are completely exposed to the risk of that security. Diversification means spreading the investments so the losses on one side can be compensated by the gains on the other side.
What you are talking about is one thing called "risk apettite", more formally known as Risk Tolerance:
Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. (emphasis added)
This means that you are willing to accept some losses in order to get a potential bigger return.
As you can see in the table above, the higher the risk tolerance, the bigger the difference between the best and worst values. That is the variability.
The right-most pie can be one example of an agressive diversified portfolio. But this does not mean you should go and buy exactly that security compostion. High-risk means playing with fire. Unless you are a professional stuntman, playing with fire usually leaves people burnt. In a financial context this usually means the money is gone.
Recommended Reading:
Diversification is spreading your investments around so that one point of risk doesn't sink your whole portfolio. The effect of having a diversified portfolio is that you've always got something that's going up (though, the corollary is that you've also always got something going down... winning overall comes by picking investments worth investing in (not to state the obvious or anything :-) ))
It's worth looking at the different types of risk you can mitigate with diversification:
Company risk
This is the risk that the company you bought actually sucks. For instance, you thought gold was going to go up, and so you bought a gold miner. Say there are only two -- ABC and XYZ. You buy XYZ. Then the CEO reveals their gold mine is played out, and the stock goes splat. You're wiped out. But gold does go up, and ABC does gangbusters, especially now they've got no competition. If you'd bought both XYZ and ABC, you would have diversified your company risk, and you would have been much better off. Say you invested $10K, $5K in each. XYZ goes to zero, and you lose that $5K. ABC goes up 120%, and is now worth $11K. So despite XYZ bankrupting, you're up 10% on your overall position.
Sector risk
You can categorize stocks by what "sector" they're in. We've already talked about one: gold miners. But there are many more, like utilities, bio-tech, transportation, banks, etc. Stocks in a sector will tend to move together, so you can be right about the company, but if the sector is out of favor, it's going to have a hard time going up.
Lets extend the above example. What if you were wrong about gold going up? Then XYZ would still be bankrupt, and ABC would be making less money so they went down as well; say, 20%. At that point, you've only got $4K left. But say that besides gold, you also thought that banks were cheap. So, you split your investment between the gold miners and a couple of banks -- lets call them LMN and OP -- for $2500 each in XYZ, ABC, LMN, and OP. Say you were wrong about gold, but right about banks; LMN goes up 15%, and OP goes up 40%.
At that point, your portfolio looks like this:
XYZ start $2500 -100% end $0
ABC start $2500 +120% end $5500
LMN start $2500 +15% end $2875
OP start $2500 +40% end $3500
For a portfolio total of: $11,875, or a total gain of 18.75%.
See how that works?
Region/Country/Currency risk
So, now what if everything's been going up in the USA, and everything seems so overpriced? Well, odds are, some area of the world is not over-bought. Like Brazil or England. So, you can buy some Brazilian or English companies, and diversify away from the USA. That way, if the market tanks here, those foreign companies aren't caught in it, and could still go up. This is the same idea as the sector risk, except it's location based, instead of business type based.
There is an additional twist to this -- currencies. The Brits use the pound, and the Brazilians use the real. Most small investors don't think about this much, but the value of currencies, including our dollar, fluctuates. If the dollar has been strong, and the pound weak (as it has been, lately), then what happens if that changes? Say you own a British bank, and the dollar weakens and the pound strengthens. Even if that bank doesn't move at all, you would still make a gain.
Example:
You buy British bank BBB for 40 pounds a share, when each pound costs $1.20. Say after a while, BBB is still 40 pounds/share, but the dollar weakened and the pound strengthened, such that each pound is now worth $1.50. You could sell BBB, and because of the currency exchange once you've got it converted back to dollars you'd have a 25% gain.
Market cap risk
Sometimes big companies do well, sometimes it's small companies. The small caps are riskier but higher returning. When you think about it, small and mid cap stocks have much more "room to run" than large caps do. It's much easier to double a company worth $1 billion than it is to double a company worth $100 billion.
Investment types
Stocks aren't the only thing you can invest in. There's also bonds, convertible bonds, CDs, preferred stocks, options and futures. It can get pretty complicated, especially the last two. But each of these investment behaves differently; and again the idea is to have something going up all the time.
The classical mix is stocks and bonds. The idea here is that when times are good, the stocks go up; when times are bad, the bonds go up (because they're safer, so more people want them), but mostly they're there to providing steady income and help keep your portfolio from cratering along with the stocks. Currently, this may not work out so well; stocks and bonds have been moving in sync for several years, and with interest rates so low they don't provide much income.
So what does this mean to you?
I'm going make some assumptions here based on your post. You said single index, self-managed, and don't lower overall risk (and return). I'm going to assume you're a small investor, young, you invest in ETFs, and the single index is the S&P 500 index ETF -- SPY.
S&P 500 is, roughly, the 500 biggest companies in the USA. Further, it's weighted -- how much of each stock is in the index -- such that the bigger the company is, the bigger a percentage of the index it is. If slickcharts is right, the top 5 companies combined are already 11% of the index! (Apple, Microsoft, Exxon, Amazon, and Johnson & Johnson). The smallest, News Corp, is a measly 0.008% of the index.
In other words, if all you're invested in is SPY, you're invested in a handfull of giant american companies, and a little bit of other stuff besides.
To diversify:
Company risk and sector risk aren't really relevant to you, since you want broad market ETFs; they've already got that covered. The first thing I would do is add some smaller companies -- get some ETFs for mid cap, and small cap value (not small cap growth; it sucks for structural reasons). Examples are IWR for mid-cap and VBR for small-cap value.
After you've done that, and are comfortable with what you have, it may be time to branch out internationally. You can get ETFs for regions (such as the EU - check out IEV), or countries (like Japan - see EWJ). But you'd probably want to start with one that's "all major countries that aren't the USA" - check out EFA.
In any case, don't go too crazy with it. As index investing goes, the S&P 500 is not a bad way to go. Feed in anything else a little bit at a time, and take the time to really understand what it is you're investing in.
So for example, using the ETFs I mentioned, add in 10% each IWR and VBR. Then after you're comfortable, maybe add 10% EFA, and raise IWR to 20%. What the ultimate percentages are, of course, is something you have to decide for yourself.
Or, you could just chuck it all and buy a single Target Date Retirement fund from, say, Vanguard or T. Rowe Price and just not worry about it.
I would like to first point out that there is nothing special about a self-managed investment portfolio as compared to one managed by someone else. With some exceptions, you can put together exactly the same investment portfolio yourself as a professional investor could put together for you. Not uncommonly, too, at a lower cost (and remember that cost is among the, if not the, best indicator(s) of how your investment portfolio will perform over time).
Diversification is the concept of not "putting all your eggs in one basket". The idea here is that there are things that happen together because they have a common cause, and by spreading your investments in ways such that not all of your investments have the same underlying risks, you reduce your overall risk.
The technical term for risk is generally volatility, meaning how much (in this case the price of) something fluctuates over a given period of time.
A stock that falls 30% one month and then climbs 40% the next month is more volatile than one that falls 3% the first month and climbs 4% the second month. The former is riskier because if for some reason you need to sell when it is down, you lose a larger portion of your original investment with the former stock than with the latter.
Diversification, thus, is reducing commonality between your investments, generally but not necessarily in an attempt to reduce the risk of all investments moving in the same direction by the same amount at the same time.
You can diversify in various ways:
Do you see where I am going with this?
A well-diversed portfolio will tend to have a mix of equity in your own country and a variety of other countries, spread out over different types of equity (company stock, corporate bonds, government bonds, ...), in different sectors of the economy, in countries with differing growth patterns. It may contain uncommon classes of investments such as precious metals.
A poorly diversified portfolio will likely be restricted to either some particular geographical area, type of equity or investment, focus on some particular sector of the economy (such as medicine or vehicle manufacturers), or so on.
The poorly diversified portfolio can do better in the short term, if you time it just right and happen to pick exactly the right thing to buy or sell. This is incredibly hard to do, as you are basically working against everyone who gets paid to do that kind of work full time, plus computer-algorithm-based trading which is programmed to look for any exploitable patterns. It is virtually impossible to do for any real length of time. Thus, the well-diversified portfolio tends to do better over time.
