Regardless of the investing environment, diversification can help lower total portfolio volatility and stabilize, or even increase, returns. This wonderful illustration demonstrates just how important diversification is and what impact combining multiple asset classes can have in your portfolio.
In trying to communicate about investments and constructing portfolios, I’m always on the lookout for easy to grasp representations of important concepts. This is one of the most intuitive ways to understand the promise of diversification. I stumbled upon it in Roger Gibson’s book, “Asset Allocation: Balancing Financial Risk.” Since it was the fourth edition (written in 2008), I decided to recreate it to reflect performance up until 2022.
To set up the graphic: risk on the bottom (horizontal axis), so in general, you’d want less risk and want to be as left as possible. Return is vertical over on the left, so you’d want to be higher rather than lower. Of course, everybody has different preferences, which is why different people will answer the questions under the chart differently.
Assume that the next fifty years look like the last fifty years, and without knowing which is which, answer the following questions:
- If you had to choose between owning a randomly chosen blue dot versus a randomly chosen red dot, which would you choose?
- If you had to choose between owning a randomly chosen orange dot versus a randomly chosen red dot, which would you choose?
- If you had to choose between owning the green dot versus a randomly chosen orange dot, which would you choose?
- What happens to risk and reward as you go from blue to red to orange to green?
Most people, according to Gibson, choose the green circle. It’s actually the best mathematically, as it has the highest Sharpe ratio (a measure of reward for a given unit of risk). So, what’s the green circle and what are all the others?
This chart shows the power of diversification, or holding multiple types of assets in a portfolio.
- The blue dots represent 100% positions in Large-cap Growth stocks, Small-cap Value stocks, 10-Year Treasury bonds, and Gold.
- The red dots represent all six possible combinations of assets, with half in one and half in the other.
- The orange dots represent the four possible combinations of three of the assets, so one-third in each.
- The green dot represents a portfolio combining all four in equal measure.
See the pattern? As you combine assets, risk goes down quite a lot, with maybe some decline in reward, but generally not all that much. This “trick” works with any four assets as long as they are less than perfectly correlated assets and have positive expected returns, though the four assets chosen here produce a particularly obvious portfolio due to their profiles. This is an illustration of the power of combining negatively correlated and uncorrelated assets:
Here are the return and standard deviation figures for the portfolios. Data from Portfolio Visualizer.