We've all heard the old adage about not putting in your eggs in one basket. This is good advice. But why? The basic premise of investing is to be rewarded for risk that you take. That's why savings accounts pay you essentially nothing in interest; they are assumed to be very safe places to store money. That said, it makes sense that you would want to be paid as much return possible for every "unit" of risk. Diversifying does exactly that. Done CORRECTLY, diversifying your portfolio can increase the per unit return that you receive for every unit of risk. To understand this concept, we need to quickly define 3 things:
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Expected Return
This is the return that you expect to receive for investing in something. Coming up with this value is an entire universe of topics which we will delve into later.
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Standard Deviation (one measure of risk)
A statistical measure of volatility. It answers the question "On average, how much different was each year's return from the long term average?"
Standard deviation (std. dev.) is always calculated with historical data... that is, you can look at historical returns and calculate the average return. Std. dev. is the average DIFFERENCE between each year's actual return and that single average you calculated for the whole time period.
Example:
- 10 year average return=y;
- Year 1 return = x;
- Year 1 difference = x-y.
- Do that again for years 2, 3, 4...
- then take the average of all 10 of those differences..
- THAT is standard deviation
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Correlation (the key ingredient)
Another statistical measure, it is the tendency for two values to move together or opposite of one another. Correlation is always a number between -1 and 1.
I also want to point out that most investments have a positive expected return. What this means is that when you add a second or third investment to your portfolio, particularly when those investments have a low or negative correlation to one another, you begin to see some investments with positive returns in weeks that other investments have negative ones. The overall effect on the portfolio is that the week to week value of the portfolio fluctuates a lot less than if you had just one of those investments. In other words, you lower the standard deviation of the PORTFOLIO by adding other investments that have a low correlation to the initial investments. The expected return, however, is still positive because each one of your investments is expected to give you a positive rate of return. In other words, you get to the same place, it just takes a lot less up and down to get there. Depending on what you were invested in initially, it is possible to earn the same return that you were with one investment, but reduce the fluctuation in value (volatility) of the portfolio as a whole. Volatility is an especially important risk to consider when the likelihood that you will need to withdraw from your investments in the near or medium-term. You've just made some moves that give you more return for less volatility.