What is portfolio diversification and how can it reduce risk?

In general, the movements of stocks and bonds and commodities and real estate are not strongly correlated. Just because the stock market is down doesn't mean the real estate market will be down. In general, the returns on these investment classes are independent of each other. By putting some money into each class, you're able to reduce your risk while theoretically maintaining your return on investment.

This might sound complicated, but it's not. Think of it this way: If I ask you to bet $100 on the flip of a coin, and promise to give you $220 if you make the right call, but I get to keep the $100 if you lose, you would probably refuse. The risk is too high. But if I asked you to agree to stake $100 on each of ten similar coin tosses, would you do it? I suspect you might. Your expected rate of return is still the same (10%), but your risk is significantly reduced.

That is the power of diversification. Each coin flip is like owning an individual stock. Buy owning more stocks, you can maintain a similar rate of return while decreasing your risk. (Note that you also reduce your potential gains, however.)

You can diversify your investments simply by adding a couple funds to your portfolio. You might put 10% of your money into a bond fund, for example, and 10% into a real estate investment trust (which is like a mutual fund for real estate). In the same way that it's better to own more than one stock, it's also better to own more than just stocks.

The two best discussions of diversification I've found are in:

These are both great books for beginning investors. They're not technical, and they approach the subject with the average person in mind. Both of them note that there are several ways to approach diversification, including:

  • Diversification among stocks. “If you want to take some extra money and gamble it on some high-flying biotech stock, go ahead,” Malkiel writes. “But for your serious retirement money, don't buy individual stocks — buy mutual funds.” In particular, he recommends a portfolio of index funds.
  • Diversification among asset classes. In Investing 101, Kristof spends 32 pages discussing the importance of diversification, exploring different asset classes in detail. She discusses investing for safety (with cash or cash equivalents), investing for income (with certificates of deposit, Treasury bonds, REITs, etc.), investing for growth (with stocks and mutual funds), and investments that protect you from inflation (such as precious metals). She discusses the pros and cons of each class, and explains why the ideal portfolio has a little of each.
  • Diversification over time. Many investors practice dollar-cost averaging as a means to mitigate risk. (Though most of us dollar-cost average because we don't have huge lump sums to invest.) Malkiel writes, “Periodic investments of equal dollar amounts in common stocks can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices.” (Please note that dollar-cost averaging has critics with valid points.)

Some investors also diversify internationally, or within asset classes (owning both CDs and Treasury bonds, for example).

How much should you diversify? And which investments should you choose? There's no one right answer. The answer depends on you and your financial goals. The U.S. Government Securities and Exchange Commission has an excellent beginners' guide to asset allocation, diversification, and rebalancing. If you'd like to learn more about this subject, it's a great place to start. (I also found an asset allocation calculator, but I wouldn't take the results as gospel. Use them as a starting point, but make your own decisions.)

If you had to choose just three types of assets that should be in a well-diversified, long-term investment portfolio, what would they be? If we polled the Get Rich Slowly audience, we'd get a range of responses to that question. However, I think plenty of folks would have answered “bonds, U.S. stocks, and international stocks.” Which is perfect, because those are the investments in the demonstration of asset allocation that I'm about to embark upon.

Let's look at the returns of three mutual funds from 30 June 1989 to 30 June 2009: The Fidelity Intermediate Bond Fund (FTHRX), which holds bonds that mature in five or so years; the Vanguard 500 (VFINX), which very closely mimics the performance of the Standard & Poor's 500 index of large U.S. stocks; and the T. Rowe Price International Discovery Fund (PRIDX), which invests in small companies from all over the world.

We can make a few observations about these returns:

  • Compounding is cool. Even by just earning approximately 6% a year, the initial investment more than tripled over two decades. Earn a bit over 9%, and you could almost sextuple your investment (and have fun saying “sextuple” to your friends).
  • Higher return comes with higher risk. Yes, the T. Rowe Price fund posted the best long-term performance, but its worst years were really worse.
  • You don't always get that higher return. While the Vanguard 500 beat the Fidelity bond fund, that was due to the extraordinary returns of stocks in the 1990s. Over the past decade, U.S. large-company stocks actually have lost to bonds. (In fact, as I wrote over at The Motley Fool, the return on such stocks from 1999-2008 was even worse than the 10-year returns during the Depression.)
  • Earning a little bit more can lead to big bucks. The annualized return of the Vanguard 500 was just 1.52% more than the annualized return on the Fidelity bond fund. Yet the difference in the amount $100,000 grew to after 20 years was huge; the Vanguard 500 earned an extra $108,568, 33% more than what an investor earned in the bond fund. I've said it before, and I'll say it again: That's the power of earning a little bit more — or paying a little bit less — over the long term. (It is pure coincidence that the difference between the returns of the two funds, or 1.52%, is very close to the average expense ratio charged by actively managed mutual funds. But it's a telling illustration: If you're paying that much annually to invest in a mutual fund, but not getting superior results in return, you could be giving up tens of thousands of dollars.)

Let's say you are given these three investment choices for the next 20 years. How would you allocate your portfolio? If you're an aggressive investor, you might put all your money in the T. Rowe Price International Fund. But could you stand such large declines? And what if international small companies don't do as well over the next 20 years?

If you're a conservative investor, however, you might go the opposite direction and put all your money in the bond fund. Your portfolio would be nice and steady, likely avoiding sleep-disrupting double-digit annual declines. But, if the future is anything like the past, you could potentially be passing up $100,000 to $200,000 in gains. Perhaps that's playing it too safe.

Let's try a simple solution: Investing one-third of the portfolio into each of those funds and rebalancing annually. What do you think the annual return would be?

You might pick a number that is the average of the annualized returns on those funds, which would be 7.67%. But here are the actual numbers:

Well, looky there. You got a return that beat the arithmetic average of the three returns. It significantly outperformed the S&P 500, and it did so with a lot less volatility (as indicated by its worst years not being as bad). By owning assets that move in different directions at different degrees and at different times, along with some regular rebalancing, you get a return that beats the average returns of the investments in the portfolio. The whole is greater than the sum of its parts.

Sure, that extra return is less than 1% a year. But we've already demonstrated how earning a little for a long time really adds up. And that return beat the return of two of the portfolio's three components. As I wrote in May, asset allocation means you don't have to predict which type of investment will do best — which can be dangerous, because you could be wrong.

A well-diversified portfolio provides a respectable return, with lower volatility than a portfolio of just one type of stocks. Not a bad deal at all.

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