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Why Diversify?
By Adam Jared Apt
November 23, 2010


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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics.  To view all the articles in this series, click on “More by the same author” in the left margin.

And though the tired waves vainly breaking
Seem here no painful inch to gain,
Far back, through creeks and inlets making,
Comes silent, flooding in the main.

Clough

There is an old amusement of pairing proverbs that encapsulate opposing tidbits of folk wisdom, like “A stitch in time saves nine,” and “Haste makes waste.” Similarly, there is “Don’t put all your eggs in one basket,” paired with the quotation, “Put all your eggs in one basket, and then watch that basket,” which is not exactly a proverb, but a maxim of Andrew Carnegie’s that was picked up and popularized by Mark Twain.

Although the diversification of investments (not putting all your eggs in one basket) is commonly regarded as a good thing, there are nonetheless those who regard it as a guarantee of mediocrity. It isn’t, but there are right ways and wrong ways to go about diversifying a portfolio. Let’s first explore how diversification works.  Then we will understand how it can help us, and what its limitations are.

There are contexts where diversification is inappropriate, and where Carnegie’s advice is apposite.  Our society and its economy flourish because of entrepreneurs, individuals who conceive ideas for businesses and put them into practice.  These persons are often supreme risk-takers, and many do, indeed, fail.  They must put their all into their businesses, and they do not diversify. For the most part, they are different from ordinary investors, and not only because they are willing to take extraordinary risks; they also have a large measure of operational control over their investments.  If the enterprise is not going well, they have the power to change the way it works.  Ordinary, that is, passive investors lack this power.  If a business in which they’ve invested isn’t going well, their only option is to sell their stake. The option to sell your stake in a company after it has done badly is not, however, operational control.  So Carnegie’s advice is exactly right for entrepreneurs, as it was for him.  The rest of us, whose wealth is in common stocks, bonds, mutual funds, and exchange-traded funds, and who lack operational control over our investments, can benefit from diversification, when it is done thoughtfully.

How diversification works

Diversification works its wonders in two ways: it can reduce risk, and (though this is generally a lesser effect and not widely acknowledged), it can actually increase returns.

The usual explanation of diversification, unfortunately, often stokes the doubts of skeptics. You may well have heard an investment expert justify diversification on the grounds that it dampens volatility.  The argument is that some of your investments will be going up as others are going down. The net change in your portfolio of investments is therefore less than the extreme changes of the individual investments.  This explanation, while not incorrect, is incomplete, and it often provokes the not unreasonable retort that volatility doesn’t matter, because what really matters is how an investment turns out in the long run. Other explanations of investment diversification that rely on analogy to the role of diversity in different realms—you know, like the admonition to eat a diverse diet—are substitutes for thought, not aids to understanding.

Consider, for the moment, a world in which you have perfect foreknowledge of investments.  In this world, you would put all your money into the one investment that you knew would have the highest return (after taking into consideration all cash flows).  Why invest in anything that would produce less than the highest return?

But wait! Although we’ve assumed perfect foreknowledge of investment performance, we haven’t assumed perfect foreknowledge of when you would want to cash in your chips. What is the span of time we’re considering?  Would you choose the investment that would have the highest return by 4:00 PM on Tuesday, March 2, 2021?  But the price might drop the next morning, and perhaps a different investment would have the highest return as of 4:00 PM on Wednesday, March 3, 2021, one day later.  Having perfect foreknowledge of investments, you should choose that one instead, if your target date is March 3, rather than March 2.

Only rarely does someone know the precise date and time when he will have to convert his investments, in whole or in part, to cash. That uncertainty, even apart from the uncertainty (in the real world) about future investment performance, means that we normally invest in more than one thing in order to have some hope of good results at that vague time in the future when we have to cash in.  That is, we diversify.

If you put a portion of your money into at least one additional investment, you’re diversifying.  Then the question is no longer whether to diversify, but how much should you diversify, and with what.

Diversification can beat mediocrity

I’ve just shown that if you don’t know the precise length of the long run, even if you do know future investment performance—which you don’t—then variability (of price or return), that is to say, investment risk, matters. Thanks to variability, the investment that will produce the best investment result in precisely twelve years is not necessarily the same as the investment that will produce the best investment result in twelve years and one day, or in fifteen years.

But variability matters also even if you do know the precise length of the long run but don’t know the final value of the investment. Diversification’s ability to reduce variability can produce investment results that are superior to those of a single investment.

Let’s consider, for example, the possibility of investing just in the U.S. stock market, and then of investing in both the U.S. and the Chinese stock markets.  Let’s assume that the U.S. stock market and the Chinese stock markets will each return a precise average of 7% a year over the next five years. And let’s say that that the pattern of (variable) returns turns out as follows:

Stock Market

2011

2012

2013

2014

2015

Average

Wealth

U.S. 6% -8% 7% 20% 10% 7% $137,737
China 1%  2% 10% 10% 12% 7% $139,613

Now, although they achieve the same average annual return, the U.S. stock market and the Chinese stock market will have different results.  If you invest $100,000 in each market at the beginning of 2010, your investment in the U.S.  will grow to $137,737 at the end of 2014, whereas your investment in China will grow to $139,613, a difference of $1,875.46.1

Look at the numbers.  Even without knowing statistical definitions of volatility, you can see at a glance that our hypothetical Chinese stock market is less variable than the hypothetical U.S. stock market.

It is a general truth that, for the same average return, the less variable pattern of returns will always produce more wealth.2 This can be proven mathematically. And it is a corollary of my assertion when I discussed the nature of return,3 that what matters in the end is not return, but the amount of money.

But at the beginning of 2011, we don’t know the patterns of future returns, although our best estimate (in this example) is that both the U.S. and the Chinese stock markets will have the same return over the long run.  So we diversify.  We invest $50,000 in the U.S. stock market, and $50,000 in the Chinese stock market. The returns to this diversified portfolio are then:


Stock Market

2011

2012

2013

2014

2015

Average

Wealth

U.S. + China 3.5% -3% 8.5% 15% 11% 7% $139,047

That is, the return in each year is just the average of the returns to the U.S. and Chinese stock markets for that year (so that, in 2011, 3.5% = (6% + 1%)/2).4 This diversified portfolio of two investments, which again will average a return of 7%, will produce final wealth of $139,047.  This isn’t quite as good as investing in just the Chinese stock market alone ($139,613, as we just saw); it’s $566 less.


1. And, no, the order of the returns doesn’t matter. Readers familiar with the mathematics of compound growth can confirm these results in a minute or less with a calculator or spreadsheet.

2. Devoted and attentive readers will recognize this example and the argument as being nearly a repeat of one presented in my earlier essay, Peabody River Newsletter, issue 2, July 2009, “How to Think about Investment Return and Risk at the Same Time, Part I.”

3. Peabody River Newsletter, issue 2, July 2008, “How to Think about Investment Returns.”

4. Because the money invested in each market grows at different rates each year, I have to sum my resulting wealth at the end of each year, divide it in half, and reinvest each half in each market. Otherwise, I’d be investing more in one market than the other at the start of each successive year.

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