This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the advisor for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.

Imagine it’s 30 April 1989. You just came into a hundred grand. You plan on investing this money for the next 20 years. Where do you put it?

Here are four options. No need to look them up on Morningstar (in fact, that would be cheating for today’s exercise). Just glance at them and choose which of the four you think would have been the best place for your money over the past two decades.

  • Fidelity International Discovery (FIGRX): Invests in larger companies headquartered outside of the U.S., mostly in developed countries.
  • Fidelity Real Estate Investment (FRESX): Invests in real estate investment trusts (REITs), real estate operating companies (REOCs), and small pigs (RUNTs). Just kidding on that last one.
  • Vanguard 500 (VFINX): An index fund that seeks to mimic the performance of the S&P 500 index of generally large U.S. stocks.
  • Vanguard Small-Cap Index Fund (NAESX): An index fund that seeks to mimic the performance of the MSCI U.S. Small Cap 1750 Index of small to middle-sized U.S. stocks.

Go ahead and choose one, and just one. Where would you have committed your money for the past 20 years? Got one? Great. Now, let’s see how they each performed since 30 April 1989, and how much your $100,000 would be worth today.

Fund Avg. Return $100K Turned Into…
Fidelity International Discovery 6.41% $346,605
Fidelity Real Estate Investment 8.13% $478,046
Vanguard 500 7.52% $426,704
Vanguard Small-Cap Index Fund 7.44% $420,637

Source: Morningstar Principia software, 4/30/1989-4/30/2009

Did you pick Fidelity Real Estate Investment, the fund with the highest return? My guess is you didn’t, not after what has happened in the real estate markets over the past few years. Perhaps you picked Fidelity International Discovery, since somewhere in the back of your mind is the recollection that international stocks beat U.S. stocks every year from 2002 to 2007. But that was the lowest-returning of our choices. And while it lost to the real estate fund by just 1.72% a year, that disadvantage resulted in $131,441 less wealth — an amount greater than the original $100,000 investment. Compound small amounts over many years, and you’re talking big bucks.

The power of diversification
Now, when I asked you to pick just one of these investments, you may have resisted. “I would never invest all my money in just one fund,” you might have said. “That’s too risky.”

You’re so smart.

But while you know that diversification lowers risk, did you know that it can also boost returns? Let’s see by creating a portfolio that is invested 25% in each of the aforementioned funds, and rebalance it annually. What do you think the average annual return on this portfolio would have been? Where would it rank among the returns of the four funds?

You can attempt to come up with an answer by doing a little math: Add up the returns of the funds and divide by four. That would give you 7.35%, which would have lagged all the choices except the international fund.

But here’s the real answer: The four-fund portfolio, rebalanced annually, would have earned an average 7.81% a year, turning $100,000 into $450,279. That beat three of the four choices; the sum exceeded most of the parts, so to speak.

How did that happen?

A bit of balance
While each of the funds posted similar long-term returns, they often rose and fell in different degrees, at different times. This didn’t happen each and every year; 2008 is a recent and painful example of how many investments can move in the same direction (i.e., down) at the same time. But looking over many years, some of these funds zigged while the others zagged.

Throw in some rebalancing — which entails selling what has done relatively well to buy what has not — and you’re often getting out of a hot asset class before it turns cold, and getting into a laggard that’s ready to become a leader. In fact, studies indicate that rebalancing annually is generally too much. Had we rebalanced our hypothetical portfolio every three years (something I can’t do with the otherwise excellent Morningstar software I used to run these numbers), I think the return of the four-fund portfolio would have been a tad higher.

Yes, it lagged the No. 1 performer (the real estate fund). But here’s the real beauty of asset allocation: You don’t need to identify what will be the very best investment (which is pretty hard, if not impossible). No fortune-telling skills are required. You get very respectable returns without paying a psychic or selling your soul.

Final notes
Finally, I’ll point out that I’m not recommending this exact portfolio or these exact funds; they were chosen because they have long-enough histories to examine (though I will say that I am partial to index funds, and own shares of the Vanguard 500). This is just an illustration of a neat little asset-allocation trick, which also works when you switch up the investments (as shown in this longer-term illustration).

A real-life portfolio should have even more assets, including bonds if you’re financially conservative or within a decade of retirement. But that’s a topic for another day.

For more investing information, check out The Motley Fool’s Rule Your Retirement service.

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