Diversification Is Better than a Free

Clients often ask about a particular stock or what the next hot stock sector will be. (My response is always a rendition of: “I don’t know the future and neither do you.”) 

Luckily, arithmetic is much more foreseeable, however, and we know that investors as a whole will earn the market return minus costs. Nobel laureate economist Harry Markowitz coined the concept of “the only free lunch,” meaning that diversification is the only way to reduce your portfolio’s risk, without simultaneously reducing its expected returns. 

My take is that diversification is even better than a free lunch.

The Theory of Diversification

Diversification is so valuable using a very simplistic example (that I used to present when I taught investing.) Let’s say there were two companies: Rainy Day Umbrellas (RDU) and Sunny Sunscreen (SSI). A further simplification is that a year is either sunny or rainy and there is a 50% chance of either. In a sunny year, RDU doesn’t sell many umbrellas and declines by 10% while SSI gains 30%, selling a lot of sunscreen. In a rainy year, the opposite happens. You will invest for two years. If you pick one stock, on average you will be right one year and wrong the other. Your expected return is (1.3 x 0.9) – 1 or 17%. The average annual return (known as the geometric return) is 8.2%. It doesn’t matter if you were right the first or second year, only that you were right one year and wrong the other.  

Now, instead of picking one stock, say you put half in each. You would earn a guaranteed 10% return each year as one stock would lose 10% while the other would gain 30%. After the first year, you rebalance so that half of your proceeds are back at each stock. You will again get a guaranteed 10%. Over the two-year period, you get a 21% return (1.1 x 1.1) -1. You earn 21% instead of 17%, or four percentage points more.  

A couple of things to note before we leave theory land. First, the arithmetic average return for the two years is 10% whether you diversified or not. Second, the total returns (also known as geometric) were very different in that the lower amount of volatility (in the second case, zero), the closer the geometric return was to the arithmetic return. 

Back to Reality

In the example above, diversification not only reduced the volatility, it increased the total returns. It was beyond a free lunch in that you actually got paid to eat that delicious meal. In reality, of course, no assets (I know of) have both an attractive return expectation combined with a negative one correlation. But asset classes with lower correlations can both decrease risk and increase expected returns. You may not get paid as much as the four-percentage point increase in returns (21% vs. 17%) but you do get paid by lowering volatility from diversification.

Let’s look at some real data to check out the theory. It turns out that 96% of stocks, on average, return about the same as a short-term Treasury Bill, according to a study by Hendrik Bessembinder at Arizona State University. A handful of stocks, like Nvidia, account for all of the excess returns over a T-Bill. Even a portfolio of 100 stocks has less than a 50% chance of earning the market return. Thus, the portfolio would likely have a higher volatility, but the same average arithmetic return. With higher volatility, the geometric return is likely to be lower than owning the entire market.

Investor Returns

Sure, arithmetic and geometric returns are paramount, but the most important return is the investor return and that’s what the investor actually earns. Morningstar does an annual study called “Mind the Gap” where they calculate both the fund return and the actual investor return. Because investors generally chase past returns, they time the markets and asset classes poorly. On average, Morningstar finds the average investor return to be 1.2 percentage points lower than the fund (geometric) return based on the ten years ending on December 31, 2024. But let’s look at the gaps by fund type from the lowest diversification to the highest. Sector funds have a gap of 1.5%, while those differences are much lower in US Equities (0.6%) and Asset Allocation (0.1%).

The narrowest funds (sector) have the widest gap, showing more performance chasing, while asset allocation funds have the lowest gap, or the least amount of performance chasing. Note that adding other asset classes, such as high-quality bonds can not only lower volatility, they can also increase returns because they typically rebalance rather than chase past performance.

Don’t Get All Emotional. Diversification is one of the four key ingredients of investing, which I define simply in eight words: “maximize diversification and discipline; minimize expenses and emotions.” Own the entire world in total US and total international stock index funds along with high quality bonds, including inflation protected securities. Own them at the lowest costs and have the discipline to rebalance. When clients’ emotions are telling them that they know more than the market does, ignore those sentiments. Instead, tell them: “Let’s not take uncompensated risk with an expected lower return.”