🌱 The BEST Reason to Diversify Your Portfolio You’ve Never Heard Before
If you are an investor, you’ve heard that you should diversify your portfolio. You may have even heard the opposite – that only people who don’t know how to invest need to diversify.
The reasons why you should diversify can be found easily enough. You've been told that diversification leads to:
- Risk Reduction: If one asset tanks, others may hold steady or even rise, cushioning the blow.
- Smoother Returns: Diversified portfolios tend to experience less volatility over time.
- Opportunity Expansion: Exposure to different sectors and regions opens doors to growth you might otherwise miss.
- Peace of Mind: Knowing your investments aren’t all tied to one outcome can help you sleep better at night.
Those reasons are true and they are good. But there’s an even better one.
But before we get into it, I want you to know that this is new information and that you've not heard it before is no fault of yours. The truth is, in all my years of financial education, from University of Toronto, three courses at the Canadian Securities Institute, the CPA and the CFA, this is something I was never taught. And that’s because, as far as I know, we uncovered it, at INVRS.
When we were writing our Portfolio Management course, we wondered, if you have time on your side and you have the fortitude not to stray from your plan when the market corrects or crashes, does it really make sense to include assets that historically underperform stocks?
So, we investigated it.
What we discovered was a surprise and it is simply this:
Volatility erodes compounded returns.
This means that you can have two portfolios with identical average returns, but the one with the least volatility will have a higher compound return, and in investing, it’s the compound return that counts.
This is simple to test yourself, but below is an example that uses three hypothetical portfolios, A, B and C.
They all have the same average return, 10%, but each portfolio becomes progressively more volatile. You can measure volatility using standard deviation, or simply look at the range of returns.
|
Portfolio A |
Portfolio B |
Portfolio C |
|||||||||
|
Periods |
Return |
Return +1 |
Value |
Return |
Return +1 |
Value |
Return |
Return +1 |
Value |
||
|
1 |
1 |
1 |
|||||||||
|
1 |
10% |
110% |
1.1 |
10% |
110% |
1.1 |
25% |
125% |
1.25 |
||
|
2 |
12% |
112% |
1.23 |
15% |
115% |
1.27 |
-5% |
95% |
1.19 |
||
|
3 |
8% |
108% |
1.33 |
5% |
105% |
1.33 |
30% |
130% |
1.54 |
||
|
4 |
13% |
113% |
1.50 |
18% |
118% |
1.57 |
-10% |
90% |
1.39 |
||
|
5 |
7% |
107% |
1.61 |
2% |
102% |
1.60 |
28% |
128% |
1.78 |
||
|
6 |
12% |
112% |
1.80 |
20% |
120% |
1.92 |
-8% |
92% |
1.64 |
||
|
7 |
8% |
108% |
1.95 |
0% |
100% |
1.92 |
24% |
124% |
2.03 |
||
|
8 |
13% |
113% |
2.20 |
22% |
122% |
2.34 |
-4% |
96% |
1.95 |
||
|
9 |
7% |
107% |
2.35 |
-2% |
98% |
2.29 |
32% |
132% |
2.57 |
||
|
10 |
10% |
110% |
2.59 |
10% |
110% |
2.52 |
-12% |
88% |
2.26 |
||
|
Average |
10% |
10% |
10% |
||||||||
|
CAGR |
10.0% |
10.0% |
9.70% |
9.70% |
8.5% |
8.5% |
|||||
|
Standard Deviation |
2.40% |
8.60% |
19.03% |
||||||||
|
Range of Returns |
7% - 13% |
-2% - 22% |
-12% - 32% |
||||||||
The big take away is, C, the most volatile portfolio, loses 1.5% of CAGR (compounded annual growth rate) compared to portfolio A, the least volatile.
Assuming each portfolio starts with $100, after 10 years, Portfolio A is worth $258.82, B $252.30 and C $226.24.
In my opinion, this is a tremendous insight.
Let’s look at this from another perspective. Let's introduce a fourth portfolio, D, and compare it to C. D is much less volatile and it sacrifices average return compare to C. Yet it still delivers exactly the same compounded return at a fraction of the risk.
|
Portfolio C |
Portfolio D |
|||||||
|
Periods |
Return |
Return +1 |
Value |
Return |
Return +1 |
Value |
||
|
1 |
1 |
|||||||
|
1 |
25% |
125% |
1.25 |
9% |
109% |
1.09 |
||
|
2 |
-5% |
95% |
1.19 |
11% |
111% |
1.21 |
||
|
3 |
30% |
130% |
1.54 |
8% |
108% |
1.31 |
||
|
4 |
-10% |
90% |
1.39 |
9% |
109% |
1.42 |
||
|
5 |
28% |
128% |
1.78 |
7% |
107% |
1.52 |
||
|
6 |
-8% |
92% |
1.64 |
7% |
107% |
1.63 |
||
|
7 |
24% |
124% |
2.03 |
8% |
108% |
1.76 |
||
|
8 |
-4% |
96% |
1.95 |
9% |
109% |
1.92 |
||
|
9 |
32% |
132% |
2.57 |
7% |
107% |
2.05 |
||
|
10 |
-12% |
88% |
2.26 |
10% |
110% |
2.26 |
||
|
Average |
10% |
8.5% |
||||||
|
CAGR |
8.5% |
8.5% |
8.5% |
8.5% |
||||
|
Standard Deviation |
19.03% |
1.35% |
||||||
|
Range of Returns |
-12% - 32% |
7% - 13% |
||||||
🧠How Diversification Fits In
What we want is for diversification to reduce our portfolio’s volatility. That’s the key.
Volatility is reduced by combining assets that have uncorrelated returns. In our Portfolio Management course, we introduce the use of a matrix to help people build diversified portfolios, which I’ll cover in another blog post. This is another INVRS innovation, I might add.
But for now, you can build diversification into your portfolio by investing across:
- Asset Classes: Mix equities, fixed income, real estate, and alternative
- Within Asset Classes: Own stocks from different sectors (tech, healthcare, energy) and sizes (small-cap, mid-cap, large-cap).
- Geographically: Invest in both domestic and international markets to hedge against regional downturns.
- By Investment Style: Blend growth and value strategies to balance potential and stability.
🚀 Final Thoughts
Diversification is an easy win to improve your portfolio’s long-term success. Remember, comparing the average return of two portfolios does not provide enough information. The range of returns, and/or the standard deviations is a vital component of a performance evaluation.
