The platitude that more risk can lead to more return is absolutely true…when you talk about basic math like your average annual return on an investment. But at the portfolio level, the math works a little bit differently.

 

lifesadragblogA positive average annual rate of return across your portfolio doesn’t necessarily mean you’ll make money over the long-term, especially in volatile markets. How can that be?

The simplest of 50-50 odds proves my case: a coin flip.

With odds that good, it would be natural to just bet it all every time. Ten flips equals 10 chances to double your money, right?

[drizzle]In reality, fortune favors more cautious portfolio construction. Taking half the risk each time actually makes you more in the end. What’s more, the ride toward higher returns will be smoother as well.

 

Making portfolio math work for you

That paradox is due to a principle in portfolio math called volatility drag.

If your account suffered a 20% loss in the front half of the year due to volatility, gaining 20% in the back half still puts you behind. You suffered a 2.25% loss—even though your average return was zero. That’s why Wall Street reports annualized returns so frequently.

Now imagine that happening in your portfolio quarter after quarter and year after year. Good performing investments, poor portfolio results. There has to be a better way, and there is. It’s called diversification.

Diversification as a profit center

One way to stop this cycle is to stop thinking of diversification as a cost center. Start examining the benefits of diversification. Ask fewer questions about how many basis points an investment costs, or how it stacks up using traditional benchmarks.  The benefits of diversification can become more concrete through questions like:

  • Is this investment uncorrelated to stocks and bonds?
  • Does this asset class historically outperform in bear markets when I need it the most?
  • Does this investment actually incorporate a different kind of risk in my portfolio, or does it just diversify in name only?

By taking less risk and having a portion of your principal uncorrelated to the volatile markets, you could possibly turn diversification from a cost center to a profit producer.

J.P. Morgan’s suspicion that volatility is “probably here to stay” isn’t far off base. Despite stock valuations at all-time highs, volatility still plagues the market, with 2015 resulting in the worst U.S. stock performance since 2008 and 2016’s Brexit blindside showing the stock market can give up all the year’s gains in just one day.

The good news is that just because the market swings up and down doesn’t mean your portfolio has to. In fact, the goal of a portfolio that includes assets uncorrelated to stocks and bonds is to try and preserve returns while also limiting volatility and downside.

Is life a drag in a volatile market? It can be if you’re betting all in on the traditional portfolio.

[/drizzle]