How Diversification Works: Understanding Diversification for a Better Portfolio — Transcript

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1. 0:00everyone knows that diversification is a
2. 0:03good thing for your
3. 0:04portfolio but do you know how it works
4. 0:07do you know why it works Beyond not
5. 0:10putting all of your eggs in one basket
6. 0:14let me back up I think it's pretty safe
7. 0:16to say that the financial markets are
8. 0:19pretty noisy they bounce all over the
9. 0:22place and while there's some signal some
10. 0:25piece of the returns that are meaningful
11. 0:29are really big chunk of a stocks return
12. 0:32is just noise that doesn't really matter
13. 0:36especially in the short term and that's
14. 0:39where
15. 0:40diversification which is sort of just a
16. 0:42fancy way of saying owning a whole bunch
17. 0:45of stuff in your portfolio comes in and
18. 0:49I really am serious about
19. 0:50diversification really just being owning
20. 0:53a whole bunch of stuff because the whole
21. 0:56idea is that owning all of these
22. 0:59different things
23. 1:00all of these different stocks that are
24. 1:02all bouncing around semi randomly will
25. 1:05mean that the random part of that return
26. 1:08the noise will cancel itself
27. 1:11out this means that you're left with the
28. 1:14nonrandom part of the return the
29. 1:16meaningful part of the return that's the
30. 1:19whole reason we invest in the financial
31. 1:21markets in the first place if you want
32. 1:24to dive into understanding why this non
33. 1:27diversifiable risk is so important and
34. 1:30useful for investing take a look at our
35. 1:32article taking the risks that make sense
36. 1:36I've got the link down in the
37. 1:37description below but for now let's take
38. 1:41it as a given that there are risks in
39. 1:43the market that we want to take on
40. 1:46otherwise what's the point of
41. 1:49investing effectively diversification
42. 1:52clears the board and allows us to focus
43. 1:55on those good risks that we actually
44. 1:58want in our port portfolio but I want to
45. 2:01call out a common
46. 2:03misconception having a diversified
47. 2:06portfolio does not mean that you've
48. 2:08gotten rid of all of the risk and that
49. 2:11your portfolio can't go down we've just
50. 2:14been talking about how it lets us focus
51. 2:16on the risks that matter what it does is
52. 2:20clears out all of the junk it
53. 2:23substantially reduces all of the
54. 2:26unhelpful risks that you would get from
55. 2:28investing in a single company or a small
56. 2:31group of companies so how does it do
57. 2:35this well let's look at an example we'll
58. 2:38start simple with a single stock and
59. 2:40just to be clear this is an example I've
60. 2:42created out a whole cloth nothing we're
61. 2:45about to look at are real returns let's
62. 2:48start with that single stock and we'll
63. 2:51assume that we know that the stock has
64. 2:53an expected annual average return of 10%
65. 2:56and standard deviation of
66. 2:5830% and let's let's say we look at the
67. 3:00stock over the next 30 years if we plot
68. 3:03out the return it'll look something like
69. 3:05this when all is said and done this
70. 3:08stock had a pretty darn good 30-year
71. 3:11period and came up with an average
72. 3:13return of almost
73. 3:1511% and a standard deviation of about
74. 3:1927% essentially we got lucky with a good
75. 3:22return and a little bit less bumpy of a
76. 3:24ride than we would have expected
77. 3:27otherwise but what if we had a portfolio
78. 3:29of 10 stocks including that one that we
79. 3:32just looked at over those same 30 years
80. 3:36well it's actually a little bit of a
81. 3:38mixb the average return just by chance
82. 3:41was a little bit lower across the
83. 3:43portfolio but we can already see just
84. 3:46how much less bumpy the chart is we
85. 3:49reduced our standard deviation from 27%
86. 3:52for the single stock all the way down to
87. 3:55a little less than 9% for the portfolio
88. 4:00and we'll come back to the effects of
89. 4:01that slightly lower average return in a
90. 4:04minute but we can do better what if we
91. 4:07had a 100 stocks rather than 10 well as
92. 4:12you can see the line gets even less
93. 4:14bumpy than before and now the portfolio
94. 4:17standard deviation is
95. 4:2025% now I don't want to belabor this I
96. 4:22think you kind of get the joke at this
97. 4:24point but what happens with a thousand
98. 4:27stocks well this an all but straight
99. 4:31line in fact the portfolio standard
100. 4:34deviation is
101. 4:370.9% per
102. 4:39year and it's important to recognize
103. 4:41that this isn't just valuable for
104. 4:43reducing how bumpy of a ride your
105. 4:45Investments are taking you on Lower
106. 4:48volatility all else being equal means
107. 4:51higher total returns this is because
108. 4:55returns aren't symmetric for instance
109. 4:58let's say your portfolio Los es half of
110. 5:00its value in a year it goes down by
111. 5:0350% hopefully this never happens but if
112. 5:07it does getting a 50% return the next
113. 5:11year won't make you whole again to get
114. 5:14all the way back to where you were you
115. 5:16would need to double your money so
116. 5:19instead of just looking at the
117. 5:20year-by-year
118. 5:22returns let's say we invested $100 in
119. 5:25each of these portfolios at the start of
120. 5:27those 30 years what would it look like
121. 5:30at the
122. 5:31end as we can see there's a really big
123. 5:34difference remember how I said that the
124. 5:37average return of the single stock was
125. 5:39pretty good and the average return of
126. 5:41the 10 stock portfolio was a little bit
127. 5:44lower well to put some numbers around
128. 5:46this the single stock had an average
129. 5:49return of 10.9% per year and the 10
130. 5:53stock portfolio had an average return of
131. 5:569.8% per year over those 30 years that
132. 6:001% difference is a big deal but look at
133. 6:05what happens when we factor in the
134. 6:07volatility that volatility reduction is
135. 6:10massively important we went from an
136. 6:13ending value of
137. 6:15$853 for a single stock all the way up
138. 6:18to
139. 6:19$1,500 for the 10 stock
140. 6:22portfolio even with that lower return
141. 6:27just by reducing the noise in the
142. 6:30portfolio and the 100 and thousand stock
143. 6:33portfolios they did even
144. 6:35better this is why diversification is so
145. 6:38important it may reduce the chances of
146. 6:41you betting it all on the next apple but
147. 6:44it increases the chances of you having
148. 6:46an overall good investing
149. 6:50experience and I know which one I want
150. 6:52to focus on in my retirement plan now
151. 6:56this is a stylized example since these
152. 6:59are all just random returns based on
153. 7:02distribution all of the stocks are
154. 7:04completely uncorrelated with each other
155. 7:07how one moves has no impact on how the
156. 7:10others move so we're going to see some
157. 7:14pretty drastic effects even with the
158. 7:16smaller portfolios like the T stock
159. 7:19portfolio in terms of the effects of
160. 7:22diversification but the principle is the
161. 7:25same as you add in more and more
162. 7:29different Securities which aren't going
163. 7:31to move exactly like each other those
164. 7:34differences will keep chipping away at
165. 7:36the random noise in the markets exposing
166. 7:39the risks that we actually want to be
167. 7:41building our investments around and this
168. 7:44is why diversification is such a good
169. 7:46thing for your portfolio and your
170. 7:49retirement it's pretty much the only
171. 7:52free lunch in
172. 7:53investing normally to get higher returns
173. 7:57you have to take on more risk or if you
174. 7:59want lower risk you have to accept lower
175. 8:03returns diversification is pretty much
176. 8:06the only thing that you can be doing
177. 8:09that can improve your overall returns
178. 8:12and reduce your portfolio risk at the
179. 8:15same time it's not a magic wand though
180. 8:19nothing in retirement planning is if the
181. 8:22markets as a whole drop your portfolio
182. 8:25is going to drop right along with it but
183. 8:28that market risk is the whole point of
184. 8:30investing it's the reason that you don't
185. 8:33just keep your money in a savings
186. 8:34account and if you want to find out more
187. 8:37about why that is and what else you can
188. 8:40be doing with your Investment Portfolio
189. 8:42to help you reach the retirement that
190. 8:43you want you should take a look at our
191. 8:45free ebook the nine principles of
192. 8:48intelligent investors you can download
193. 8:50it for free by going to retirement
194. 8:52researcher. comom principles it's here
195. 8:55on screen and we've also got it linked
196. 8:56down in the description below this will
197. 8:59help you take this framework for how the
198. 9:01markets work and understand what to do
199. 9:04with that in a practical sense and what
200. 9:07that means for your Investment
201. 9:09Portfolio if this was helpful be sure to
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