What Is Diversification
Batteries are a pretty amazing product. With batteries, we are able to power electrical devices anywhere in the world. AA batteries are by far the most popular battery size in the world, so maybe you should start your own business where you sell just AA batteries. Row after row of floor to ceiling AA batteries. Millions of AA batteries. Your success or failure would be dependent entirely on the demand for AA batteries, which would likely ebb and flow more than you would prefer. You would probably decide that you need more product offerings to stabilize the income stream from your business.
Investments are no different
You don’t want to put 100% of your wealth into one asset. Investing in one and only one asset is too much of a gamble. You might pick the asset that ends up being the best performing asset of all time. However, it’s just as likely that it would end up losing significant value and cost you much of your wealth. It’s harder to determine future winners and losers than you might think. In the late 1990s Enron Corporation traded as high as $90.56, was a darling of Wall Street and was named “America’s Most Innovative Company” by Fortune magazine for six consecutive years between 1996 and 2001. By the end of 2001, Enron was bankrupt and worthless. Investors lost. Poorly diversified investors with large portions of Enron stock saw their net worth collapse.
Smoothing the ride
Unless an asset is risk-free, there will be times when it goes up in value and times when it goes down in value. Not all assets are the same. Some will go up and down more than others. Some will go up when others go down. When held together these differences smooth the ebbs and flows of your portfolio. Consider Asset A and Asset B.
See table – The Return Smoothing Power of Diversification
Asset A goes up by 50% when asset B goes down by 25%, and Asset B goes up by 40% when Asset A goes down by 35%. Both assets go through period of high positive returns and high negative returns. They just do it at different times. A portfolio that holds 50% of each asset has lower positive returns, but it also never has negative returns. In all three cases, the average arithmetic return is 7.5%. The ride is different, and the ebbs and flows are diminished by holding both assets.
The whole is better than the sum of the parts
Look at the table showing the growth of $100 given the returns of each asset and the combined 50/50 portfolio.
See table – Growth of $100
Asset A has the most extreme ups and downs which comes at the cost the $100 investment declining to $95.06 at the end of period 4. Asset B grows to $110.25 despite its positive returns being lower than Asset A’s positive returns. The portfolio that rebalances to 50% of Asset A and 50% of Asset B at the end of each period grows to $132.97, which is better than either of the individual assets.
Risk and return
Asset A has the highest risk and the lowest return. The 50/50 portfolio has the lowest risk and the highest return. In general, investors expect to be compensated for holding riskier assets with higher returns, but that’s not the case in this example. What is going on? With the 50/50 portfolio you were able to diversify away some of the risk of holding either asset by itself. In general, you are not compensated for accepting risk that can be diversified away.
The Return Smoothing Power of Diversification
Growth of $100
*We work hard to make these articles as approachable and math-free as possible. At the same time, if a little math makes the article easier to understand, we’ll go ahead and do that too.