Portfolio Diversification

Market Returns was the title of the last article in this series. It reviewed the historical performances of a broad selection of stocks and bonds. This article looks at portfolio diversification or what combining different assets does to both return and risk.

Portfolio diversification deals with holding more than one asset or mutual fund in a portfolio. It generally reduces the risk and the returns.

Before looking at some numbers, it is important to understand risk.

Human Beings and Risk

Positive returns are good. People like them to be larger rather than smaller. Yet the volatility of returns is not considered good. If people only focused on returns they would choose that investment that had the highest expected return. Instead, people behave in a manner that takes the volatility or uncertainty of returns into account.

Humans are “pre-configured” to like return and dislike risk. Some show more caution (risk aversion) than others, but we are all risk averse to varying degrees. This statement holds even for those who take pride in being risk takers.

To illustrate, I relay an example I used in the classroom. Students consider themselves bullet-proof and risk-averse (pre-SnowFlake era).

The class, individually, is offered a choice to receive $1.00 or the opportunity to flip a coin which would pay $3.00 if heads turned up and nothing if tails did. The offer was one-time only. The expected value of the coin flip is $1.50 and the expected value (certain value) of the alternative is $1.00. Most of the class voted to play the game, supposedly nullifying risk aversion.

There were several likely reasons for this choice. The trivial amount was likely a major one Another was the fact that win or lose, their life would not change. The fact that they could not lose anything and the diversion of class time to an irrelevant activity also played roles.

Then the offer was changed by a factor of 10. Now I would hand you $10 or you could flip a coin with the chance of winning $30 or zero. Fewer people were willing to flip the coin, preferring the certain $10. There were still holdouts, so the game increased by another factor of 10. Ask and you can have a $100 bill or flip a coin with the chance of three of them or nothing. Most chose the $100 instead of running the risk of nothing.

There were always some holdouts who loved the spotlight. For them, the game was raised by a factor of 100 this time. You can ask and receive $10,000 or flip a coin with a head producing $30,000 or a tail, zero. Usually, at this point everyone accepts the sure thing. If not, we go to $1,000,000 vs gambling between $3,000,000 or zero. Even those with great bravado realize their silliness and begrudgingly take the $1 million. 

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