Unlocking the Power of Diversification: The Key to Financial Success

By: Joe Morgan

May 18, 2023 | DiversificationLong-Term PortfolioFinancial PlanningInvestment Strategy

It is unfortunate, but to understand why diversification works, we must understand a little math. And here it is:

If we take a series of returns (say +4%, -5%, +9%, -1%), we can simply add them up to get what our total return would be (+7%). In math, they call this a linear relationship – which simply means we can straight-forwardly add these numbers up to get the total.

To gauge the variability of this series is a bit more complicated. To do this, we take the average of the series and then calculate the difference between each point and the average. This tells us how far, on average, each period’s return deviates from the average. Math folks call this the standard deviation.

When we take two series and combine them together, a little magic happens: the standard deviation gets smaller than adding the two standard deviations individually. This is a non-linear relationship.

Because returns are linear and variability is nonlinear, we can get to the same returns with less variability by combining two investments that have different returns in each period but end up with the same return over the long run.

This is why diversification works: we get the sum of the returns with less than the sum of the risk.

This mathematical magic is the key to constructing a portfolio that your well-thought-out financial plan deserves: a beautifully diversified investment strategy!

So, what do you think?
Is your investment plan optimized to take full advantage of this mathematical magic? Does it include diversification within asset classes (like stocks vs. bonds) as well as among them? Is it being rebalanced on a regular basis to ensure the best approach remains in place regardless how markets move?

To share your comments, send me a direct email at joe@bestfinlife.com.
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