Why diversifying risk is a better way to build portfolio wealth.
The ideal conditions for achieving investment success are created by disciplined application of three major themes found in modern prudent fiduciary investing: broad diversification of risk, low costs, and (for taxable investors) low taxes. These factors, upon which the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule) place such great emphasis, help give investors the best chance of building the long-term wealth of their portfolios while reducing risk.
It's not hard to understand (although too little acknowledged) that every dollar saved in investment costs and taxes goes straight to the bottom line to increase return. However, not many investors (including fiduciaries that are responsible for managing other people's money) understand that broad diversification of risk can also increase return.
In fact, an investor has much better odds of building portfolio wealth through broad diversification of risk than trying to pick stocks or time markets. To better grasp this, it's necessary to first understand a few simple yet fundamental rules of basic arithmetic that govern investment gain and loss.
Keeping Portfolio Volatility Low to Reduce Loss
The constant (increasing and decreasing) changes in the values of the investments held in a portfolio through time generate portfolio "volatility." In the following examples, basic rules of arithmetic show how reducing volatility (or risk) can reduce loss. (We will also see how reducing volatility risk can enhance gain. By the way, I equate "volatility" with "risk," which I define as standard deviation in this article. While using standard deviation as a measure of risk is not ideal (e.g., it encompasses both bad "uncompensated" risk and good compensated" risk), nonetheless it can help illustrate a basic concept: the reduction of a portfolio's volatility reduces loss and can also enhance gain.
Suppose that you have $100 in your portfolio and achieve a 50% gain. You then incur a 50% loss on your portfolio. Most people would say that you broke even: A 50% gain followed by a 50% loss is "a wash." Most people would be wrong.
What actually happened is that the 50% gain on the $100 gave you $150 and the 50% loss on that $150 gave you $75. So you did not break even but, in fact, suffered a net loss of $25. Reversing this sequence to incur a 50% loss first and then a 50% gain results in the same amount of net loss: $25.
This example helps show how the arithmetic of gain and loss can have such an impact--often negative--on portfolio wealth. This example also introduces the first simple rule governing investment gain and loss: Any given percentage loss hurts a portfolio more dollar-wise than a percentage gain of the same magnitude.