Higher Returns With Lower Risk — The Magic Of Diversification

We’ve all heard the phrase “Don’t put all your eggs in one basket”. This is a very simple way to explain diversification. If the basket is damaged, and the eggs in it break, you may end up losing all of them.

In the investing world, how exactly does diversification work? And what is the right way to diversify your investments? Let’s try and understand this fundamental concept using a series of very simple graphs.

Diversification

Stocks Vs. Bonds

Most people describe investment risk using the example of stocks and bonds. Stocks are considered high-risk while Bonds are low-risk investments. Also, we’re told that high risk = high return.

If you look at the graph below comparing the Risk and Return of Long-Term Government Bonds (considered risk-free) and the S&P 500 index, that seems like true. This is Investing 101, right?

Wrong! If this were true, an investor who did not want to lose money would put 100% in Bonds and 0% in Stocks. However, you have many more options. You could have invested 10% in Bonds, and 90% in Stocks. Or you could have invested 50% in each. Plotting these possibilities on the same graph, you see the something like the below curve.

The most important and interesting thing to notice in this graph, is that a portfolio of 40% Stocks,60% Bonds would have given you a higher return for a lower risk level than a portfolio of 100% Bonds.

Take a moment to understand this point. Isn’t it surprising?

The point at which the curve turns is called the Minimum Variance Point. As an investor, you should never be below this point (seen highlighted in red below) as your risk is higher even though your returns are lower.

Where you want to be on the green portion below, depends on your risk appetite — it is here that the “high risk = high return” principle holds true.

Diversification with more asset types

Taking the same principle of diversification further, we can add more types of assets and compare the results for these portfolios as well. As expected, the more you diversify, the lower your risk levels go.

The blue line below shows what happens when you add Real Estate to the Stocks and Bonds graph. The green line shows the result of adding small-cap stocks into the mix.

Diversification helps reduce your overall risk without compromising on returns.

Why does this matter?

Let’s take an example of a portfolio that has Asset ‘A’ and Asset ‘B’. Take a look at the graph below.

If you invested 100% in Asset A, 100% in Asset B or 50–50 in both, at the end of 5 years you will have 50% return from all three options so as an investor you may wonder what difference does the diversification make?

While the returns at the end of 5 years are the same, you can see that the Purple line above is much smoother. So if you withdraw your money at the end of Year 1, the purple line does better than Asset A. At the end of Year 2, it does better than Asset B and so on.

Volatility is part of all investments. Hence, a diversified portfolio is advisable to give you an optimal return on investment at all stages of the investment cycle.

Conclusion

Even today, there are millions of investors who have 100% Bond investments because they think this is a low-risk approach to investing. As the above explanation says, a diversified portfolio can have a lower risk level and simultaneously give you higher returns.

While it is impossible to construct the best possible portfolio without predicting the future, the key takeaway for investors is that a non-diversified portfolio is not a very wise choice.


Credits -

This theory about diversification benefits is from the 1952 Modern Portfolio Theory by Harry Markowitz. He was awarded the Nobel Prize for this work.

The above graphs are from an excellent write-up about the Efficient Frontier by Prime Capital Equities.