Diversification Is the Only Free Lunch

Diversification Is the Only Free Lunch

We’ve all heard the clichéd advice to not “put all your eggs in one basket” – and, while the phrase is trite, the benefits of diversification are real and powerful. Diversification is the only “free lunch” in the investment world – combining two or more assets with the same expected returns, but a less than perfect (less than 1.0) correlation to each other will lower your portfolio risk (standard deviation) without lowering your expected returns – and the lower the correlation to each other, the stronger the portfolio risk-reduction benefits. This synergy allows you to build portfolios that are greater than the sum of their parts. Typical diversification – such as owning the stock of different companies, different industries, or even different countries will provide a diversification benefit, but only to a limited extent. Stocks, even those of completely different companies in totally different industries or countries, as a whole, still exhibit a fairly high degree of correlation to each other – for a powerful example, think back to the financial crisis in 2008 and how U.S., International, and even Emerging Markets equities all fell steeply at the same time. Further, the benefits of diversification using moderately correlated assets such as various types of equities (0.66 correlation – red line) begin to fade after more than a few new assets are added, as shown by the flattening of the red line as it moves to the right – maxing out at an almost 20% portfolio risk reduction. An almost 20% portfolio risk reduction benefit is good – but you can do better.

Portfolio Risk Reduction from Adding Diversifying Assets

In order to really see the power of diversification one needs to turn to investment assets that exhibit truly low (or even near zero) correlations to the rest of your portfolio. Investable asset classes with these characteristics and solid expected returns can be hard to find – but the benefits are astounding. A portfolio made up of 6 equally-weighted assets, each with a 10% expected return and 10% standard deviation, and a true 0.0 correlation to each other (totally uncorrelated) will have a 60% reduction in portfolio risk over any one of the holdings – without giving up any returns. This is incredibly powerful.

Asset classes like private real estate, reinsurance, variance risk premium capture, alternative lending, infrastructure, agriculture and timber have very low correlations to more common asset classes like stocks and bonds. When we mix them together intelligently, we utilize the power of Wiser Diversification.

Building Benjamins is one the few Registered Investment Advisers (RIAs) to take full advantage of this Wiser Diversification to build Stronger Portfolios for our clients. Read more here or our detailed white paper.

Investors deserve Wiser Diversification, Stronger Portfolios and higher risk-adjusted returns. We would love to walk you through how this process helps our investors.

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