Diversifying Well Is The Most Important Thing You Need To Do In Order To Invest Well

Summary

• It's very hard to make money in the markets for the same reason that it's hard to make winning bets at the racetrack.
• Diversification can improve your expected return-risk ratio by more than anything else you can do.
• Excellent diversification with rebalancing to the desired diversified mix both reduces risk and raises expected returns.

One of my most overarching principles is "knowing how to deal well with what you don't know is much more important than anything you know."

Related to this is my fundamental investment principle that "diversifying well is the most important thing you need to do in order to invest well."

This is true because 1) in the markets, that which is unknown is much greater than that which can be known (relative to what is already discounted in the markets), and 2) diversification can improve your expected return-to-risk ratio by more than anything else you can do.

It's very hard to make money in the markets for the same reason that it's hard to make winning bets at the racetrack: because the unknowns are so large in relation to what is "discounted" or "priced in." Just as it's pretty easy to pick good horses that will likely outperform bad ones at the racetrack, it's pretty easy to pick good companies that will likely do better than poor ones in a market. The hard part is converting this knowledge into winning bets because of how the payoffs reflect what is known. The process of betting will change the expected payoffs so that betting on the worst horse in a race has about the same expected value (i.e., likelihood of winning times size of reward) as betting on the best one-and betting on the worst companies will be equally likely to pay off as betting on the best ones. As a result, most everything is about an equally good/bad bet.

Said another way: all investments compete with each other, a lot of smart investors are trying to pick the winners (which changes the pricing that determines what you will win relative to what you will lose in various outcomes) and the uncertainties of what will transpire are large relative to what is "discounted" or "priced in." This means that there are no easy good or bad bets in the markets, and that one's starting point should be that all investments are roughly equally good (i.e., their own expected risk-adjusted returns are roughly comparable).

Diversification can improve your expected return-risk ratio by more than anything else you can do. That's because while you can't know which of the items you are betting on will provide better results, you do know that they will behave differently, and by mixing them appropriately you can reduce risk. Diversifying well is a matter of knowing how to reduce your expected risk by more than you reduce your expected return (i.e., improving your return-risk ratio).

Those principles are the ones that prompted me to come up with the "risk parity" approach to creating a balanced portfolio, which we call All Weather. These principles are explained in the section of my Principles book called "Discovering the 'Holy Grail of Investing'" (pp. 56-61).

I have a few other principles that are related to what I'm going to show you about effective diversification. They are:

Extreme moves in markets and economies are largely self-correcting, because when they happen, they set into motion adjustments that tend to reverse those extremes - e.g., if prices are extremely high, that will set into motion looking for new ways of producing the item or finding substitutes for it; if some business is extremely profitable, that will attract competitors, which will change the supplies to reduce profitability. Because there is a lag between the extreme and the discovery and implementation of that which reverses it, there tends to be big overshoots in one direction followed by big moves in the other. In trying to tactically identify extremes and reversals (which I call paradigm shifts), one should look for what is happening that is unsustainable. In a moment, I will show you how this affects the results of rebalancing one's portfolio to keep it diversified after prices change. But first I want to share with you another principle, which is:

People tend to extrapolate what they have gotten used to. As a result, after an extended period of a certain type of market and economic behavior (a paradigm), it is likely to be "discounted" or "priced in" to the markets. For example, most investors tend to think that investments that have produced good returns over the past few years are good investments rather than less good investments because they're more expensive, so they inappropriately buy more near the tops and sell more near the bottoms. That is the biggest mistake in investing. On the other hand, rebalancing (i.e., selling off enough of those positions that have done better than average and buying enough of those positions that have done worse than average in order to return the actual mix of assets to the targeted mix) will likely both raise returns and reduce risk.

Because of those last two principles combined - and because policy makers tend to move to reverse extremes in the markets and economies - we have big reversals and big paradigm shifts in markets and economies. It is also why having a well-diversified portfolio that is rebalanced to maintain that diversification has a much better expected return-risk ratio than any single investment.

Another key building block investment principle is that big losses are not compensated for by big gains, so they should just be avoided at all cost. For example, if I have alternating gains and losses of 50%, I will lose a lot of money, because a 50% loss will require a 100% gain to recover from. Graphically, the results would look as follows:

The chart below shows the simulated results (over 1,000 simulations) of investing in an asset that either makes or loses 50% each period (with a 50/50 probability of gain or loss). As you can see, because losses are disproportionately difficult to recover from, over time your expected wealth is wiped out. So, you mustn't have big losses!

For these reasons, excellent diversification with rebalancing to the desired diversified mix both reduces risk and raises expected returns.

How to Diversify Well

There are many ways to diversify. Some of the biggest and most important ones are across asset classes, sectors, currencies, countries, and investment "styles" (like small cap, growth, etc., in equity markets). Regardless of which of these you look at, you will see the previously described principles play out.

To show this, on the next few pages, we show the same set of charts for all of those different ways of diversifying. The gray lines represent individual types of returns, and the black line represents the average of them, rebalanced monthly. As you will see, by and large, the average of them has much smaller losing periods, much more consistent 10-year risk-adjusted returns, and higher returns than most of the individual strategies.

It is for these reasons that I believe that diversifying well is the most important thing you need to do in order to invest well.