Linear Returns, Nonlinear Risk: A Tech-Savvy Guide to Diversification
Why Diversification Works
Diversification is a key strategy in investing. To understand why it works, we need to look at some math.
Understanding Returns
If we take a series of returns, such as +4%, -5%, +9%, -1%, we can add them up to find the total return, which is +7%. We call this a linear relationship.
Measuring Risk
Measuring risk is more complex. We need to:
- Calculate the average of the returns.
- Determine how each return differs from the average.
This difference gives us the standard deviation, which represents risk. It shows the ups and downs of an investment over time.
Where the Magic Happens
When we combine two or more series, something interesting occurs! The standard deviation is smaller than if we simply added the two together. This is a nonlinear relationship.
Returns are linear, while risk isn't. We can mix different investments. This way, we can get the same returns but with less risk. Imagine combining two waves; they can cancel each other out, resulting in a straight line.
This is why diversification works: we get the sum of the returns with less than the sum of the risk.
Building a Smooth Portfolio
In reality, we cannot find two investments that exactly cancel each other out. We can track how investments change over time. This helps us build a portfolio that meets our financial goals.
This mathematical magic is essential for a well-structured investment strategy. A diversified portfolio can help you reach your financial objectives.
Your Investment Plan
So, what do you think? Is your investment plan optimized to take full advantage of this mathematical magic? Consider these questions:
- Does it include diversification within asset classes (like stocks vs. bonds)?
- Is it diversified among different asset classes?
- Is it rebalanced regularly to adapt to market changes?