Diversification Reduces Risk
Diversification may be the most misused word in the English language. Being “diversified” does NOT mean owning 60-100 stocks, nor does it mean owning a few mutual funds.
Harry Markowitz, winner of the Nobel Prize in Economics in 1990, said while almost all diversification is good, there still exists effective and ineffective diversification. Simply put, if your assets move in tandem and move up and down together, that is ineffective diversification.
Effective diversification means your assets’ prices move in varying directions. Therefore, while one asset is doing poorly, another lowly correlated asset in your portfolio may be doing well. The effectively diversified portfolio provides stability and, hence, a larger long-term return.
A truly diversified portfolio is comprised of many asset classes that do not always have the same price movements – for example, you should diversify your assets between small cap stocks and large cap stocks, value and growth stocks, international large and small companies, international growth and value, investments in emerging and developing economies, and real estate investment trusts (REIT’s). By definition, the return of the diversified portfolio will never be as good as that of the best performing asset class in a given year. In the same vein, though, the return will never be as low as the worst-performing fund in the portfolio! The volatility will be much smoother and will result in a superior long-term return.
These ideas led the way to Modern Portfolio Theory (MPT), which elaborates on Markowitz’ philosophy. MPT states that investments should be chosen based on the importance of the relationship among all of the investments rather than focusing on the individual merits of each investment. TWRU Private Wealth Management, LLC utilizes and employs these concepts in constructing portfolios for each client. Not only does this approach aim to yield superior results, but it also provides a better investment experience for the client. Our clients are more likely to understand exactly how much risk he or she has taken on in order to reach their desired return.