Diversification as a long term investment strategy

Diversification is usually discussed as a method to lower risk. And rightly so: investing in many stocks reduces the influence of any particular holding.

But there is another, lesser talked about benefit to diversification: big returns for long-term investors.

I learned about this benefit during a high school investment seminar, and it has stuck with me till this day. The example was refreshing and I hope you’ll find it interesting as well.

An exercise

Suppose you are looking to invest $10,000. You’re looking to invest for retirement 25 years later.

You have two investment choices with the following characteristics:

Investment A

Offers an expected annual return 6.25% if you invest all $10,000

Investment B

Offers a blended return and money is invested in five chunks:

  • $2,000 is risky and may get lost totally
  • $2,000 is safe and breaks even
  • $2,000 is expected to earn 5% annually
  • $2,000 is expected to earn 10% annually
  • $2,000 is expected to earn 15% annually

Which investment returns more over a 25 year period? (assuming expected returns are realized)

The answer

It surprised me to learn it was investment B that won out–and by a large margin at that!

Here is the year by year breakdown:



You can see that the safe investment is a better choice for a long time. It takes about 10 years before investment B starts to look better.

But in the end, it is the compounding returns of the diversified portfolio’s high-returning chunks that win out.

The final values after 25 years are investment A is worth about $45,550 versus investment B is worth $96,280–quite the difference.

So whenever I invest in a diversified portfolio, I remind myself to keep a long-term view about the gains.

Addendum: more realistic returns

My friend points out the example is slightly misleading because 15 percent is an aggressive expectation, not one that is sustainable over 25 years.

So let’s take a more realistic example. Suppose the guaranteed return is more like 4 percent, and the tiered diversified portfolio returns 5, 7.5, and 10 percent. Even in this case the diversified portfolio comes out on top: $42,640 versus $26,660. The diversified portfolio also lags for about 10 years.

Diversification still wins though the total returns are not as much in either case. The caveat therefore is these returns are all illustrative and should not be taken as practical expectations.



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  • evt

    I am at a loss to understand this. If if you know of an investment that earns 15% annually, why not just put 100% in that? It would outperform both A and B, without any diversification.

  • http://www.mindyourdecisions.com/blog/ Presh Talwalkar

    evt: Remember these figures are all expected returns, and higher returning investments typically entail higher risks. So it’s not as simple as putting all your money in the highest returning investment.

    The point of diversification is to spread the risk by investing in several assets that together provide stability and returns. Investment B is meant to show the long-term gains to this strategy. In practice, both of the investments would exhibit large swings and returns are only expected.

  • evt

    Thanks for the response Presh. However, how do the calculations which you graphed take into account the risk and volatility? I assume that they were simply calculated as a fixed percentage, which does not take into account the greater risk. It seems by the method used to calculate here (if it was simple compounding interest) would suggest that we would be best to take an investment of 15% regardless of risk, as risk is not taken into account.

    The Kelly Criterion gives an angle on the risk one should expose their bankroll too, given the expected payoff and volatility, and may shed some light in this area.

  • http://www.mindyourdecisions.com/blog/ Presh Talwalkar

    evt: Yes, these calculations are simple compound interest and do not account for risk, though they are suggestive that an investment with such a risk profile would outperform a safer fixed one.

    I will write about the Kelly Criterion–thanks for bringing it to my attention. It is fascinating mathematically.

  • evt

    It certainly is. It has been used by gamblers to manage there bankroll for ages, but astoundingly has had very little pickup in the investment community, even though E Thorp wrote a book on the topic in the late 60s (called “Beat the Market”).

    It is important to note, most gamblers (or investors for that matter) should probably shy away from Kelly betting straight up, as though it does maximize growth, this may not be the goal of every investor (for example, a retired person simply needed to keep up with inflation).

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