Some investors put all their money in one boat, the stock market. They ride the ups and downs of the market, moving things around as needed and generally trying to stay abreast of the constantly changing circumstances of business and the financial markets. If they’re smart, lucky, and/or have knowledgeable advisers, they get a decent return on investment. However, if the stock market hits an iceberg, and investors are just moving their stock funds, ETFs, and individual stocks around, those assets are essentially all in the same boat.
If the boat goes down, the investments all go down. The uber-wealthy and big institutions are not keeping all their money in one boat. They have already split up their assets into multiple boats that are navigating different courses to the destination. If you do the same, and one of those boats is delayed or damaged, you still have reasonable results. That is the wisdom of diversifying assets. You need to have some of your money in other boats. Wiser diversification is simply a better way to generate income, protect your portfolio, and compound at a faster rate than you can expect by staying only in stocks and bonds.
HOW DIVERSIFICATION WORKS
The concept of uncorrelated or completely independent asset classes is difficult to understand. I have prepared a graph that we believe helps explain the process. We have set up simplified assets that assume 0 percent correlation, or complete independence. (The real world does not quite operate like that, but to explain the concept, we have made this simplifying assumption.)
Thus, we have taken six assets with the exact same expected return (7 percent) and the exact same risk (10 percent) and run them as independent outcomes. These assets’ values are displayed as colored lines on Figure below. As you can see, the outcomes vary dramatically depending on the simulation’s random future events, even though all the assets have the exact same expected returns and risk. However, if you have a portfolio that holds all six of these assets in an equal proportion for twenty years, as shown here, the portfolio value changes are much less extreme, with less zigzag, and the return is more predictable. The thick black line shows this diversified value below. We have assumed seven distinct investments of $100,000— six single-asset portfolios for each of the six assets and one portfolio combining all six assets, equally weighted—each projected over twenty years.
Moreover, the return from the combined six-asset portfolio is much more stable and has much smaller losses than any of the individual asset portfolios has on its own. The randomly generated returns for the diversified six-asset portfolio generated a maximum loss of $1,852 in any one year. On the other hand, the worst loss of any single asset in one year was $40,508, and the single-asset portfolio with the smallest single-year loss still generated an $11,288 loss in its worst year. Diversification with uncorrelated assets allows an investor to build a portfolio that has smaller overall drawdowns and more stable, predictable returns.
To look at this another way, we have graphed the seven portfolios’ year-to-year percentage changes. As you can see, the colored lines zig and zag all over the place and are very volatile with little predictability. However, the combination portfolio, while still experiencing some variation, creates a more stable and predictable return, as shown with the black line.
Wiser diversification is nothing but math. It builds more efficient and better-optimized portfolios. Generally, the more risk you take, the higher the expected return. However, wiser diversification mixes uncorrelated assets, and therefore it is able to maintain average returns while still lowering the overall expected portfolio risk. Often, when I explain this to investors, they think it’s too good to be true. However, if you do the math, you can see how to build a portfolio with better risk-adjusted expected returns.
To learn more about wiser diversification you can download “Diversification: The Only Free Lunch” by following this link.
First featured on ForbesBooks.com