How Diversification Reduces Risk

by J.D. Roth
Published on September 29th, 2009

29Comments
This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified
Financial Planner and the advisor for The Motley Fools Rule Your Retirement service.
He contributes one new article to Get Rich Slowly every two weeks.
Quick! If you had to choose just three types of assets that should be in a well-diversified,
long-term investment portfolio, what would they be?
If we polled the Get Rich Slowly audience, wed get a range of responses to that
question. However, I think plenty of folks would have answered bonds, U.S. stocks, and
international stocks. Which is perfect, because those are the investments in the
demonstration of asset allocation that Im about to embark upon. (You are all so
accommodating!)
Lets look at the returns of three mutual funds from 30 June 1989 to 30 June 2009: The
Fidelity Intermediate Bond Fund (FTHRX), which holds bonds that mature in five or so
years; the Vanguard 500 (VFINX), which very closely mimics the performance of the
Standard & Poors 500 index of large U.S. stocks; and the T. Rowe Price International
Discovery Fund (PRIDX), which invests in small companies from all over the world.

We can make a few observations about these returns:

Compounding is cool. Even by just earning approximately 6% a year, the initial

investment more than tripled over two decades. Earn a bit over 9%, and you could
almost sextuple your investment (and have fun saying sextuple to your friends).

Higher return comes with higher risk. Yes, the T. Rowe Price fund posted the
best long-term performance, but its worst years were really worse.

You dont always get that higher return. While the Vanguard 500 beat the
Fidelity bond fund, that was due to the extraordinary returns of stocks in the 1990s. Over
the past decade, U.S. large-company stocks actually have lost to bonds. (In fact, as I
wrote over at The Motley Fool, the return on such stocks from 1999-2008 was even
worse than the 10-year returns during the Depression.)

Earning a little bit more can lead to big bucks. The annualized return of the
Vanguard 500 was just 1.52% more than the annualized return on the Fidelity bond fund.
Yet the difference in the amount $100,000 grew to after 20 years was huge; the
Vanguard 500 earned an extra $108,568, 33% more than what an investor earned in the
bond fund. Ive said it before, and Ill say it again: Thats the power of earning a little bit
more or paying a little bit less over the long term. (It is pure coincidence that the
difference between the returns of the two funds, or 1.52%, is very close to the average
expense ratio charged by actively managed mutual funds. But its a telling illustration: If
youre paying that much annually to invest in a mutual fund, but not getting superior
results in return, you could be giving up tens of thousands of dollars.)
Lets say you are given these three investment choices for the next 20 years. How would
you allocate your portfolio? If youre an aggressive investor, you might put all your
money in the T. Rowe Price International Fund. But could you stand such large declines?
And what if international small companies dont do as well over the next 20 years?
If youre a conservative investor, however, you might go the opposite direction and put all
your money in the bond fund. Your portfolio would be nice and steady, likely avoiding
sleep-disrupting double-digit annual declines. But, if the future is anything like the past,
you could potentially be passing up $100,000 to $200,000 in gains. Perhaps thats
playing it too safe.
Lets try a simple solution: Investing one-third of the portfolio into each of those funds
and rebalancing annually. What do you think the annual return would be?
You might pick a number that is the average of the annualized returns on those funds,
which would be 7.67%. But here are the actual numbers:

Well, looky there. You got a return that beat the arithmetic average of the three returns. It
significantly outperformed the S&P 500, and it did so with a lot less volatility (as
indicated by its worst years not being as bad). By owning assets that move in different
directions at different degrees and at different times, along with some regular
rebalancing, you get a return that beats the average returns of the investments in the
portfolio. The whole is greater than the sum of its parts.
Sure, that extra return is less than 1% a year. But weve already demonstrated
how earning a little for a long time really adds up. And that return beat the return of two
of the portfolios three components. As I wrote in May, asset allocation means you dont
have to predict which type of investment will do best which can be dangerous,
because you could be wrong.

A well-diversified portfolio provides a respectable return, with lower volatility than

a portfolio of just one type of stocks. Not a bad deal at all.