Trader’s Guide 2.1- Diversification

Diversification

The concept of diversification is a fundamental principle of investing, and it is one that has been embraced by many of the most successful investors in history. As Peter Lynch, former manager of the Fidelity Magellan Fund once said, "Diversification is the only free lunch in investing."

Modern Portfolio Theory, developed by economist Harry Markowitz in the 1950s, formalized the concept of diversification and demonstrated its importance in maximizing returns and minimizing risk. According to this theory, an optimal portfolio is one that is diversified across a range of assets and has the highest expected return for a given level of risk.

One of the most well-known applications of Modern Portfolio Theory is the "60/40" portfolio, which consists of 60% stocks and 40% bonds. This portfolio has become popular among investors due to its historical track record of providing a good balance between risk and return.

However, even the 60/40 portfolio is not immune to market downturns and volatility. As the investor Paul Tudor Jones once said, "You can't diversify your way to greatness. You have to be great." This underscores the importance of properly diversifying your portfolio to ensure that you are protected against market risks and uncertainties.

We will talk more about diversifying well in later chapters. Especially how concentrating exposure to a single investment or assets class can be more advantageous than diversifying broadly at specific points in the economic cycle. This is how our Macro Adaptive Portfolios outperform. Back to laying down the foundation though. As the famous investor Warren Buffett once said, "Diversification is protection against ignorance. It makes little sense if you know what you are doing."

One tool that can be helpful in the process of diversification is the correlation coefficient, which is a statistical measure that quantifies the degree to which two assets move in relation to each other. A correlation coefficient of 1 indicates that the assets move in perfect harmony, while a coefficient of -1 indicates that the assets move in opposite directions. A coefficient of 0 indicates that there is no relationship between the two assets.

To properly diversify your portfolio, you should aim to include assets that have a low or negative correlation coefficient. This means that when one asset performs poorly, the other asset may perform well, offsetting the losses and helping to reduce overall risk.

For example, consider a portfolio that includes stocks, bonds, and real estate. These three asset classes tend to have a low correlation coefficient, which means that they tend to perform differently in different market conditions. This diversification can help to reduce the overall risk of the portfolio and increase the chances of achieving your financial goals.

To illustrate the importance of diversification, let's consider a numerical example. Imagine that you have a portfolio with the following investments:

• Stock A: 50%

• Stock B: 30%

• Bond C: 20%

If both Stock A and Stock B experience a 10% decline in value, your portfolio would suffer a loss of 8%. However, if you had diversified your portfolio to include a bond with a low correlation coefficient to stocks, the loss may have been less severe.

For example, if you had added Bond D to your portfolio with the following allocation:

• Stock A: 40%

• Stock B: 30%

• Bond C: 15%

• Bond D: 15%

If both Stock A and Stock B experienced a 10% decline in value, your portfolio would suffer a loss of only 6%. This demonstrates how diversification can help to limit the impact of market downturns on your portfolio.

In addition to limiting drawdowns, diversification can also enhance returns. For example, imagine that Stock A and Stock B both experience a 15% increase in value. With the non-diversified portfolio, your portfolio would see a gain of 13%. However, if you had added Bond D to your portfolio as described above, your portfolio would see a gain of 14%. This demonstrates how diversification can help to enhance returns even when multiple assets are rising in value at the same time.

It's important to note that diversification does not guarantee a profit or protect against loss. However, it can be a powerful tool for managing risk and improving the overall performance of your portfolio.

One of the most famous proponents of diversification is investor Ray Dalio, who has said, "The single most important thing that leads to success in investing is diversification." Dalio is the founder of Bridgewater Associates, one of the largest and most successful hedge funds in the world, and he has built his investment strategy around the concept of diversification.

Dalio has also emphasized the importance of considering the asymmetry of risk and reward in diversification. As he has said, "You want to diversify in a way that gives you a lot of upside and not a lot of downside." In other words, it is important to choose investments that have the potential for significant gains while also minimizing the potential for significant losses.

To achieve this asymmetry of risk and reward, Dalio advocates for a "risk parity" approach to diversification, which involves allocating assets in a way that balances risk across different asset classes. This can help to reduce the overall risk of the portfolio while also increasing the potential for returns.

In addition to Dalio, other famous investors who have emphasized the importance of diversification include Peter Lynch and Warren Buffett. Lynch, who was the manager of the Fidelity Magellan Fund, once said, "Diversification is the only free lunch in investing." And Buffett has famously said, "Don't put all your eggs in one basket." Both of these investors have built their investment strategies around the concept of diversification, and they have achieved tremendous success as a result.

The concept of diversification is a fundamental principle of investing that can help to reduce risk and improve the overall performance of your portfolio. By using tools like the correlation coefficient and implementing strategies like asset allocation and risk parity, you can make informed investment decisions and build a well-diversified portfolio that is aligned with your financial goals. As the famous investors quoted in this chapter have demonstrated, the benefits of diversification are undeniable, and it is a critical component of successful investing.