Diversification: Why I think it’s important

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Diversify, diversify and…wait a minute…diversify!

As you probably have figured it out by now, I’m a big fan of passive investing. There are a number of key concepts that it’s important to understand when being an investor in this type of strategy. The definition of ETF is an example of one of those key concepts.

Another very important one is diversification.

Help me please: what’s diversification?

First of all, it’s a way of managing the risk when investing. If I invest in different types of ETF, let’s say one of stocks, another of bonds, I’m balancing the volatility that I will have to endure. Hopefully, I will have reasonable returns, with less volatility. Therefore I’m aiming to have a better risk-adjusted return than investing only in stocks for example.

Give me an example so I can see it clearly

Let’s see for example an ETF of S&P500. In the last 12 months, it had a return of 17,5%. With a volatility of 10%. If my money was totally invested in this single ETF I would have an excellent return, with some volatility. But if I prefer less volatility (because I’m too nervous and can confuse volatility with risk), I should consider adding an ETF of Bonds.

So if I had a portfolio of 2 ETF: 60% ETF S&P500 and 40% ETF US Bonds, the return in the last 12 months would have been 10,8% (not bad…) with a volatility of 6,1%.

In conclusion, I had less return (but still a decent one), with nearly half of the volatility.

I know what you’re thinking: Why should I have less return?

“Only the paranoid survive.” — Andy Grove

Because when investing for the long-term I try to see the big picture: there will have some years where the market will outperform my 60%/40% balanced portfolio, but there will be some years where I will appreciate having an extra ETF of bonds to balance my portfolio.

Example: In 2008 an ETF of US Stocks (S&P500) had a return (loss of) around -36,2% with a volatility of 41,4%. While a balanced portfolio of 60% ETF US stocks/40% ETF US bonds, had a return of around -18,8% with a volatility of 22,3%. As a result, the balanced portfolio would have been much better to endure. Therefore much easier to not panic and sell at the worst possible moment.

In conclusion: I vote “diversify”!

Finally, I will publish a table with the returns of different assets, in the last years. I use this to see that although not always evident, diversification for me is very important. (This alternative table was made with European ETF, with accumulating type of distribution)

Diversification Table

And what do you think about this? Do you agree?

Diversification Pinterest

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5 Comments on "Diversification: Why I think it’s important"

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SMM
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I’m good with 10.8%….gimme that all day :-). Especially when we become regular investors/savers, diversification becomes that much more important for stability and long-term preservation.

courtney@youraveragedough.com
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Agree that return is really good with the risk profile you have. We also are big fans of diversification, however we pick individual stocks and diversify across industry’s as well as cap sizes. Obviously more risky, but we do a decent amount of research before purchasing or selling to get comfortable with the valuations.

Troy @ Market History
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I think it’s a good idea to diversify, but not between markets. I.e. it’s a good idea to diversify between stocks, but it’s not a good idea to buy gold/bonds/other assets if you don’t know much about those assets.

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