This is Springwater’s Source, a topic or issue in personal finance and investing, shared visually. The Source will share one concept, once a month, in about a minute or less.
Educated investors understand that there is a benefit to diversification. Setting aside grandma’s warning to not put “all your eggs in one basket”, there are clear advantages to investing broadly within and across asset classes.
Let’s imagine that we have at our disposal 20 different investment types to use in our portfolio.* We can create an almost infinite number of “mixes” – from very concentrated in just one or two investments, to very well diversified across all 20 of them.
Now, let’s imagine that we look at the historical performance of these different mixes – or allocations – over a fairly long time period (the longer, the better, in fact). And then let’s plot their annualized returns, and the variability of those returns (the “standard deviation” of the returns, to use a concept from high school statistics). We’ll plot Return on the vertical axis, and Risk on the horizontal axis.
What would we ideally like to see in our chart? Well, high returns with no risk, right? That would mean a position on our chart that was in the upper left corner – representing high return on the vertical axis, and low risk on the horizontal axis.
Look at the chart above. It plots the risk and return of several allocations over a 16+ year period from January 2000 to March 2016.
What can we conclude from this chart? Well, two very important things:
First, we can see that there is no dot in the “ideal” position – the upper-left corner. What we see instead is that there are 5 dots are plotted in what looks very much like a curve, and one dot all by itself below the curve. The dots in a curve represent 5 different Springwater model portfolios – different combinations of the asset classes we use in well-diversified portfolios.
The fact that they’re in a curve, or line, suggests that you could pick any one of them, depending on your desire for return or your tolerance for risk, and know that you’re doing the “best” that you can, given the available menu of investments.
How do we know this is the best that you can do? Because there is no dot that lies above the curve! The curve represents a concept known as the “efficient frontier”. The efficient frontier represents the set of portfolios offering the highest expected return for a given level of risk that can be created with our defined group of available investments.
Second, we can see that there is one dot that lies below the curve, or efficient frontier. The green dot represents the performance of the S&P 500 Index (a proxy for large US company stocks) over this 16+ year period. It reflects a single asset class, an undiversified portfolio.
A portfolio that plots below the curve is considered “sub-optimal”. Why? Well, because by simply diversifying we could improve our portfolio’s performance for a given level of risk, or reduce our portfolio’s risk for a given level of return.
Look where the green dot lines up on the horizontal axis. It’s at about 15%. Now look above the green dot, and imagine that there aren’t just 5 portfolios making up our efficient frontier, but so many that their dots form a smooth curve. It would be possible to just move straight up from the green dot to a point on the curve, right? And by doing so we would be getting more return for the same level of risk.
This is why some economists refer to diversification as “the closest thing to a free lunch”.
* In practice, Springwater typically uses between 15-20 asset classes in our clients’ investment strategies.
** The efficient frontier is a concept introduced by Harry Markowitz and others in 1952. Markowitz would go on to win the Nobel Prize in economics for this work.