{"id":6447,"date":"2009-09-29T05:00:00","date_gmt":"2009-09-29T12:00:00","guid":{"rendered":"http:\/\/getrichslowly.org\/blog\/?p=6447"},"modified":"2020-08-30T10:01:28","modified_gmt":"2020-08-30T17:01:28","slug":"portfolio-diversification","status":"publish","type":"post","link":"https:\/\/www.getrichslowly.org\/portfolio-diversification\/","title":{"rendered":"What is portfolio diversification and how can it reduce risk?"},"content":{"rendered":"
In general<\/i>, 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<\/i>, 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.<\/p>\n
This might sound complicated, but it’s not.<\/b> 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<\/i> 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.<\/p>\n
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.)<\/p>\n
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<\/a> (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<\/i> stocks.<\/p>\n The two best discussions of diversification I’ve found are in:<\/p>\n 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:<\/p>\n Some investors also diversify internationally, or within asset classes (owning both CDs and Treasury bonds, for example).<\/p>\n How much should you diversify? And which investments should you choose? There’s no one right answer. The answer depends on you<\/i> and your financial goals. The U.S. Government Securities and Exchange Commission has an excellent<\/i> beginners’ guide to asset allocation, diversification, and rebalancing<\/a>. If you’d like to learn more about this subject, it’s a great place to start. (I also found an asset allocation calculator<\/a>, but I wouldn’t take the results as gospel. Use them as a starting point, but make your own decisions.)<\/p>\n If you had to choose just three types of assets that should be in a well-diversified, long-term investment portfolio<\/a>, 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 \u201cbonds, U.S. stocks, and international stocks.\u201d Which is perfect, because those are the investments in the demonstration of asset allocation<\/a> that I’m about to embark upon.<\/p>\n Let’s look at the returns of three mutual funds from 30 June 1989 to 30 June 2009: The Fidelity Intermediate Bond Fund (FTHRX<\/b><\/a>), which holds bonds that mature in five or so years; the Vanguard 500 (VFINX<\/b><\/a>), 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<\/b><\/a>), which invests in small companies from all over the world.<\/p>\n We can make a few observations about these returns:<\/p>\n 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?<\/p>\n 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.<\/p>\n 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?<\/p>\n 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:<\/p>\n 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.<\/p>\n 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 \u2014 which can be dangerous, because you could be wrong.<\/p>\n A well-diversified portfolio provides a respectable return, with lower volatility than a portfolio of just one type of stocks.<\/b> Not a bad deal at all.<\/p>\n","protected":false},"excerpt":{"rendered":" In general<\/i>, 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<\/i>, 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.<\/p>\n This might sound complicated, but it’s not.<\/b> 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<\/i> 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.<\/p>\n 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.)<\/p>\n","protected":false},"author":1422,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":[],"categories":[492],"acf":[],"_links":{"self":[{"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/posts\/6447"}],"collection":[{"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/users\/1422"}],"replies":[{"embeddable":true,"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/comments?post=6447"}],"version-history":[{"count":0,"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/posts\/6447\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/media?parent=6447"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.getrichslowly.org\/wp-json\/wp\/v2\/categories?post=6447"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}\n
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