A fundamental concept related to risk reduction is that of diversification. By distributing our investments across asset classes that are not related to each other—i.e. diversifying our investments—we can both increase overall return, while decreasing risk.
A coin toss example
A great example of this principle is borrowed from William Bernstein’s book, “The intelligent asset allocator”.
Imagine someone offers you two investment options.
Option 1 involves flipping a coin at the end of each year. Heads—your total savings are increased by 30%; Tails—your savings are decreased by 10%.
Option 2 splits your balance in half at the end of each year, and then applies the same coin toss transaction individually to each half.
Would you say Option 2 is better or worse than Option 1? It might seem they would be the same.
Without going into the math, the annualized return, over time, of Option 1 is 8.2%, and the risk—the standard deviation—is 20%. The annualized return of Option 2 is 9.1%, and the risk is only 14%.
By simply going with two coin tosses, we increase the return and reduce the risk. That’s the benefit of diversification!
The diversification benefits provided by Option 2 come from the fact that the two coin tosses are unrelated, or uncorrelated—i.e. the chance of getting heads on coin toss 2, is unrelated to what happened with coin toss 1.
Diversification in investing
This important concept has a number of implications for our investing:
Good — Buying the shares of 1000 companies in the stocks asset class provides more diversification benefit than buying shares of a single company.
Better — Distributing your investments across (relatively) uncorrelated asset classes, like stocks and bonds, provides more diversification benefit than single-class diversification, i.e. say, across stocks of large and small companies.
In this book, to maximize diversification benefit, we recommend distributing your investments across multiple asset classes that are as uncorrelated as possible.
What to expect from diversification
An interesting—and perhaps paradoxical—consequence of diversification is that, at all times, some of your investments should be doing good, while others should be doing bad. It’s important to know this up front, so that you won’t expect all your investments to do well at the same, and that this behavior is actually beneficial in the long run!