One Chart One Idea — Diversification: The Secret to a “Free Lunch” in Investing
Understanding when it does and does not work
Economics Nobel Prize winner Harry Markowitz, the father of “Modern Portfolio Theory”, established in his 1952 seminal research that a portfolio’s risk level is not simply the sum of its components but also depends on how each position interacts (correlates).
Combining different assets with a correlation of less than 1 (meaning an asset does not move in lockstep with each other) can reduce the portfolio’s overall volatility without necessarily reducing the portfolio’s expected returns. A thoughtfully diversified portfolio can have a better risk-adjusted return (measured by the Sharpe Ratio) than its components.
The graph below shows the mathematics of diversification. The lower the correlation of the additional asset to the rest of the portfolio, the higher the volatility reduction (measured by standard deviation from the mean).
Diversification has therefore been called the “only free lunch in investing”.
