How I Developed My Diversified Index ETF Investment Portfolio Part 1: The Importance of Diversification

Asset allocation-how to allocate assets between different types of investments such as small-cap stocks and international stocks, is one of those things which everybody agrees is important, but nobody seems to know exactly how to go about doing.  When I was researching this problem, I soon learned that there seem to be some widely-accepted guidelines, but many of those guidelines seem to come from one or two primary sources which have been repeated all over the internet without much understanding of where they come from.  There also seems to be very little scientific basis for these guidelines.

Even though there is no scientific consensus for how to allocate assets, the reasons for diversifying in the first place are well-documented.  First of all, let’s define diversification as investing in different asset classes which are uncorrelated.  It follows that the less correlated two investments are, the higher the diversification potential.  A more diverse portfolio will tend to be less volatile than a less diverse one, because a large change in one investment will be balanced by a lower change (or an opposite change) in some of the other investments, which is what happens when the investments are not perfectly correlated.  This is why diversification reduces risk, but the real eye-opener is that this process increases average returns over time as well.

Why?  Because by investing in many different types of assets, if one of those assets happens to be outperforming the market, it will tend to move the entire portfolio into a positive direction.  On the other hand, one might argue that if one asset happens to be underperforming the market, it would drag the entire portfolio down, but the better way to look at this situation is to think that the rest of the portfolio is limiting the loss of that one asset rather than being dragged down by it.  This works because the entire stock market, on average, tends to gain value over time due to the fact that the world economy is growing and developing, on average, over time.

The more risky an investment, the greater the possibility that its actual returns may be different from the expected returns, while the more volatile an investment, the more prone it is to large jumps in value in a short period of time.  However, even risky, volatile investments will tend to gain value on average over time, meaning that increased risk tends to come with increased reward.  The investment may lose value in the short term, but it won’t result in a permanent loss unless the investment is sold or something drastic happens to a specific company or industry.  This risk is called unsystemic risk and is also reduced by diversification.

Of course, by diversifying too much, you will eventually end up ‘owning the market’ and therefore performing exactly as the entire global stock market is performing.  However, there is also the concept of the zero-sum game.  This concept basically says that given that the overall world stock market produces an average return over time, exactly half of all investments must be over-performing while half of all assets must be under-performing in order to produce that average return.  This means that by investing blindly, your chances of outperforming the world market are 50%, except for the fact that investing carries a cost.  This cost will reduce the return of all investments, tending to pull the average after-cost return of an investment below the average return of the market.  In short, this means that somebody would be better off investing in a low-cost fund which tracks the overall world stock market rather than a series of higher-cost investments which are too diverse and approach the results of the world stock market, because the after-cost return would be lower.

In summary, then, the effects of diversification apply to your portfolio on average and also only apply if your portfolio contains various different uncorrelated assets.  It also is affected by investment timeline-over the short term, investments, especially risk and volatile ones, can lose significant value, but if unsystemic risk is accounted for, those losses will not be realized unless the investment is sold.  Diversification tends to reduce risk and volatility and tends to increase average returns, but over-diversification tends to incur high costs of investment and causes investment returns to revert to the global average market returns.  The key, therefore, is to diversify well in order to reap the benefits, remain disciplined during economic downturns, and avoid over-diersification to the point of limiting the potential for outperformance.

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