How Diversification Slashes Investment Risks

Diversified Portfolio Effect

Unraveling the Mystery of Diversification: How It Slashes Investment Risks

Understanding Diversification's Magic

Ever wondered why diversification is the golden rule of investing? It all boils down to one thing: risk reduction. But how does it work exactly? Let's break it down. Say you're eyeing two investment options. One promises a solid 4% return, while the other boasts 5%. At first glance, the choice seems obvious—go for the 5%, right? Not so fast.

Digging into the Numbers

Let's take a look the below example. The arithmetic mean return of the two assets above is 4.8% for Asset A and 6.0% for Asset B. Here's where things get interesting. While the Asset B with 6% may seem more enticing, it also comes with higher volatility—a fancy term for risk. Meanwhile, the Asset A with 4.8% offers steadier returns with lower volatility.

Period	Asset A	Asset B	Asset A + Asset B
21 years	4 %	20 %	12 %
22 years	8 %	-10 %	-1 %
23 years	1 %	15 %	8 %
24 years	4 %	-10 %	-3 %
25 years	7 %	15 %	11.5 %
Arithmetic mean Return	4.8 %	6.0 %	5.5 %
Standard deviation	2.8 %	14.7 %	6.3 %
Compound annual growth rate	4.77%	5.15%	5.31%

However, the standard deviation, which indicates volatility, is significantly different: 2.8% for Asset A and 14.7% for Asset B.

The Diversification Effect

Now, imagine mixing both investments in a 50/50 blend. Suddenly, the picture shifts. The average return remains the similar, but the overall risk drops significantly. (i.e. standard deviation is 6.3%, indicating that the risk has decreased more than the median ((2.8+14.7)/2=8.75%)).

In addition, it can be seen that the annual conversion compound rate of return is the best at 5.31%. This magical phenomenon is what we call the diversification effect.

Maximizing Returns, Minimizing Risks

In a nutshell, diversification allows you to enjoy solid returns while cushioning against potential losses. By spreading your investments across different assets, you're not putting all your eggs in one basket. Instead, you're hedging your bets and setting yourself up for long-term success.

Conclusion: Investing Wisely

In the world of investing, knowledge is power. Understanding the ins and outs of diversification empowers you to make smarter investment choices. So, next time you're eyeing those investment options, remember—the key to success lies in diversifying your portfolio.