Published in the May 13-26, 2015 issue of Morgan Hill Life
By Dan Newquist
Dan Newquist
The popular saying, “There’s no such thing as a free lunch,” is often used to discuss the idea that nothing in life is truly free. We always have to give something to get something, even if it comes under the guise of being free. When it comes to investing, however, we feel there is something that is as close to a free lunch as possible.
That something is diversification and some argue that it is not only a free lunch, but one we get paid to eat. Why is this the case? Isn’t giving up having all of our money in the best performing asset class the cost of diversification? Aren’t we destined to mediocracy by spreading all of our proverbial eggs into so many baskets? In a given year, the answer to these cost questions is yes, but over time there are differences.
It turns out the investment math changes when we diversify. Nobel Laureate Dr. Harry Markowitz helped investors understand that by combining investments that don’t always move in the same direction, we can make our portfolios produce more consistent results and that more consistent results help us make more money over time.
Consider a simple comparison of two assets that both seem to average 10 percent on the surface, but produce different outcomes. The first asset earns 20 percent in the first year, loses 10 percent in the second and then gains 20 percent in the third. If we add all of the returns up and divide by three, we get an average return of 10 percent. This basic math produces a simple average, but it doesn’t tell the whole story.
Let’s apply this return series to a $100,000 investment. That investment grows to $120,000 in the first year, falls to $108,000 in the second and grows to $129,600 in the third. In this example we made $29,600 over the three years for a total gain of 29.6 percent.
Let’s look at the second asset. This asset earns a more consistent return of 10 percent every year, and, because it earns the same return every year for three years, the average return is 10 percent. Let’s see what happens to our $100,000 investment. In year one it grows to $110,000, in year two it grows to $121,000 and in year three it grows to $133,100. So this asset would have made $33,100 over the three years for a total gain of 33.1 percent.
Two assets with the same simple average return have different results. The first asset had a more volatile ride versus the second asset. The amount of volatility we take on when investing influences our outcomes.
When we diversify, we can earn more for the level of risk we are willing to take. Part of this extra return comes from being smarter about how we allocate our money and part of it comes from putting dissimilar, sometimes higher returning investments into our portfolio. In any case, effective diversification typically helps us earn more over time.
Dan Newquist, CFP®, AIF® is a Principal Investment Advisor Representative with RNP Advisory Services, Inc., a registered investment advisor, in Morgan Hill. He can be reached at (408) 779-0699 or [email protected]. Securities offered through Foothill Securities, Inc., member FINRA/SIPC, an unaffiliated company.
