Diversification: The oldest trick in the investment book

  • The oldest rule in the financial book is that if you want a higher expected return, you have to take on more risk. If you want to lower risk, you can only do so at the cost of expected return.
  • The recommendation that investors hold a fully diversified portfolio is wisdom that they ignore at their own peril.
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Everyone is familiar with the saying, "Don't put all your eggs in one basket." Even in Shakespeare's play, "The Merchant of Venice," written more than 400 years ago, the character Antonio demonstrates his understanding of the concept when he says: "I thank my fortune for it — my ventures are not in one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year."

Harry Markowitz's modern portfolio theory

Though savvy investors, like Shakespeare's Antonio, have long understood the benefits of diversification, it was not until the 1950s when an academic named Harry Markowitz introduced research on what he called modern portfolio theory that people were able to understand diversification in an objective, mathematical sense. This research was so groundbreaking it earned Markowitz a trip to Sweden to pick up a Nobel Prize.

Today, more than four centuries after Shakespeare and 65 years after Markowitz, I just can't help but feel the need to emphasize the importance of this same basic principle. If the amount of time an idea sticks around is any testament to its value, diversification is clearly very valuable to investors. In fact, diversification is so important for investors to understand, I will even risk beating a 400-year-old dead horse to tell you why it is so important to investors who are using their portfolios to fund their financial goals. Let's start with Markowitz's research on portfolio theory.

Diversification is the only free lunch in finance

The oldest rule in the financial book is that risk and return are related. If you want a higher expected return, you have to take on more risk. If you want to lower risk, you can only do so at the cost of expected return.

Though I always like to specify that the volatility or variability of a portfolio is not necessarily risk to a lifetime investor, in order to objectively evaluate the risk level of investment portfolios for research purposes, variability of portfolio returns is what is used. If you want a higher expected return, you have to accept more variability in your portfolio. If you want less variability, it will cost you as far as expected return.

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Enter Markowitz, who showed in his research that by building a portfolio of investments that are not perfectly positively correlated (a fancy way of saying they behave differently from one another), an investor could actually lower portfolio variability without sacrificing expected return. No wonder diversification is known as the only free lunch in finance; you actually receive the benefit of lower portfolio variability without giving anything up.

Diversification reduces overall risk

By spreading your money around to as many different companies as possible, you reduce the risk of any one of those companies losing value and taking your portfolio and lifetime financial goals along with it.

If you hold thousands of companies in your portfolio, even your very largest holding represents an insignificant portion of your portfolio, so if it becomes completely worthless it will not have a material impact on your ability to achieve your financial goals. If a single company makes up 20 percent or 30 percent of your portfolio and becomes worthless, it is not a pretty picture for your financial future.

There is no reason to take this type of concentrated risk in a portfolio; the investment opportunity set is just too big and readily available to justify being anything but well-diversified. Investment options that have almost 8,000 stocks in a single fund have become commonplace and inexpensive.

Reap the returns you need to fund your goals

Stock returns tend to be driven by a handful of stocks with particularly strong performance. The problem is that there is no possible way to know in advance who the star performers will be over the next period of time.

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If your portfolio does not own these star performers, you may miss out on some or all of the returns that are necessary to fund your life goals. The only way to ensure you own the star performers that really drive returns is to commit to owning everything.

Final thoughts

Diversification is nothing new, but any amount of discussion on the topic by financial nerds over the years is justified by its importance to investors. The recommendation that investors hold a fully diversified portfolio is wisdom that they ignore at their own peril. Though this approach is not as exciting as trying to pick the best investments, I'm sure most investors would actually prefer to avoid the "excitement" of a particular investment going awry and costing them their financial future.

Holding a diversified investment portfolio is clearly the most sensible way to fund the goals that are important to an investor. That is why financial advisors are such strong advocates for this timeless concept, and I am sure we will be talking about it for another 400 years.

(Editor's Note: This column first appeared at Investopedia.com.)

— By Paul Ruedi, financial advisor at Ruedi Wealth Management

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