From the March 2011 newsletter:
When I list “full diversification” as a core component of Mariposa’s investment strategy, what does that really mean? What’s the point of diversification?
Before answering those questions, let’s first discuss one interesting, but often overlooked, property of investments: the difference between the realized, annualized return and the average return. For example, if you experience returns of +10% in one year and then -10% in the next, your realized return is not 0%, but slightly negative (-1% if you’re calculating at home). I like to think about this relationship as a simple formula:
Annualized Return = Average Return - Risk Penalty
In the example above, the average return is zero, but the annualized return (the one that matters) is slightly negative because there is some risk. If the risk were higher (let’s say returns of +50%, then -50%), then the risk penalty would be higher, reducing the annualized return further.
Knowing this, one way to increase the type of returns that you care about (annualized) is to reduce risk without reducing average returns. The advantage of diversification is that it does just that.
Let’s look at a very simply diversified portfolio composed of 60% US stocks and 40% US bonds. This example works because bonds and stocks generally don’t move up or down together. In many cases, they move in opposite directions, absorbing some of the shock of market movements.
| Investment | Annualized Return | Average Return | Risk Penalty |
| US Stocks | 1.98% | 4.02% | 2.04% |
| US Bonds | 5.73% | 5.78% | 0.05% |
| Component Average | 2.31% | 3.54% | 1.23% |
| Actual 60-40 Portfolio | 2.85% | 3.54% | 0.69% |
| Diversification Benefit | 0.54% | 0% | 0.54% |
The total portfolio earns an annualized return that is 0.54% higher than what you would expect if you simply averaged the components. This “bonus” in annualized return is purely due to the reduction in risk, not any increases in average returns. Diversification in this case lets you capture more of the average return that is rightfully yours.
If diversification works with a very simple 60-40 portfolio, wouldn’t you want to try portfolios that are more fully diversified? You can easily add investments such as real estate, foreign stocks, and commodities to diversify and reduce risk even further. And these are the results if you do that, while still keeping the overall percentages as 60% risky assets (stocks, real estate, and commodities) and 40% bonds:
| Investment | Annualized Return | Average Return | Risk Penalty |
| Component Average | 7.14% | 9.34% | 2.19% |
| Actual Portfolio | 8.54% | 9.34% | 0.80% |
| Diversification Benefit | 1.40% | 0% | 1.40% |
In this case, the diversification benefit is 1.40% per year. The addition of investments that move differently from US stocks and bonds provides a significant return boost, even if the average return doesn’t change.
So ignore active mutual funds, Morningstar ratings, or even earnings forecasts, just select an asset allocation that has the appropriate level of risk and diversification for you and rebalance periodically. Then spend the extra time and returns on activities you actually enjoy.