Why Diversify? (Why Not Put All Your Eggs into One Basket)
Diversification, the practice of hedging one's bets by investing in a range of different instruments, has gotten a bad rap in some circles recently. For US-based equity investors in particular, the idea of looking beyond American markets may seem particularly unappealing given that the US stock markets have returned over 280% since the lows of the Great Financial Crisis, when other Developed Economy stock markets have returned a measly 75%[1]. No wonder that the tactic is sometimes heralded as di-worse-ification.
So why did Nobel Laureate Harry Markowitz once refer to diversification as the only free lunch in investing? It turns out that diversifying across assets with low correlation is a great way to reduce the aggregate risk of your portfolio. For example, if you constructed a basket of two uncorrelated investments that each have a standard deviation [2] of 10%, the basket itself would only have a standard deviation of 7.1%, lower than each of the individual investments.
Diversification can also be very effective in eliminating idiosyncratic risk from your portfolio. When considering the risk of an investment, we commonly divide the risk between idiosyncratic and systematic risk. Idiosyncratic risk is risk that is applicable only to one or a few particular investments, whereas systematic risk can affect a whole market. In most common market theories, we hypothesize that investors are rewarded with higher returns by taking more systematic risk, but not idiosyncratic risk, so an investor that invests in only a few individual companies is taking more risk than they have to for their expected return.
Let’s consider a highly idealized scenario, in which I offer you a game in which you have a 99% chance of quadrupling your money, and a 1% chance of losing your full investment. If this was a one-off game, the payoff looks pretty good, but there’s a catch - you have to play the game 200 times in a row. The game is now heavily stacked in my favor, as you only have to get unlucky once to lose your whole investment, no matter how much you’ve won up to that point.
A slight modification to the game makes it much more attractive of an investment - now I offer you 10 bets per round, each with a 99% chance of doubling your money, and a 1% chance of losing your investment. Even though the amount you expect to get per bet is now much lower, you can also spread your capital evenly between each of the 10 bets, and so you’re extremely unlikely to lose more than 10% of your wealth on any bet.
Of course, in the real world, our likely payoffs are much smaller, but the main principle still holds. Finding 10 investments with similar returns but different risk-profiles and hedging your bets across them is likely to be a much safer investment than going all - in on one of them - who doesn’t like a free lunch?
[1] Comparing total returns of VTI (US) vs VEA (International Developed) between January 1st, 2009 and March 1st, 2020
[2] A standard measure of volatility and risk