Diversification

Optimizing Diversification

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Quiz!

Which of the following is a free lunch when diversifying? (Multiple correct answers.)

  1. Adding stock investments in Germany to a portfolio that holds France and Italy.
  2. Adding stock investments in Australia to a portfolio that holds Thailand and Mexico.
  3. Adding stock investments in Brazil to a portfolio that holds India and China.
  4. Adding bond investments to a stock portfolio.
  5. Adding a AAA bond to a portfolio of AAA bonds.

Optimizing Diversification

Diversification of investments is known as a free lunch. If you hold multiple investments (1) with similar returns that (2) don’t go up and down perfectly at the same time, you get the same returns with lower volatility – a free lunch.

Another type of diversification involves adding a lower-returns investment for the benefit of its lower volatility. A common example is adding bonds to a stock portfolio. Thanks to the imperfect correlation as well as the lower volatility of bonds, it lowers the volatility of the portfolio, but it also lowers the expected returns. This is appropriate when needing or desiring lower volatility, whether for financial or psychological/discipline reasons, and depends on your specific circumstances and preferences.

The key point when diversifying is to be aware when the lunch isn’t free and to strike the right balance of volatility and expected returns.

Quiz Answer:

Which of the following is a free lunch when diversifying?

  1. Adding stock investments in Germany to a portfolio that holds France and Italy. [Correct Answer]
  2. Adding stock investments in Australia to a portfolio that holds Thailand and Mexico.
  3. Adding stock investments in Brazil to a portfolio that holds India and China. [Correct Answer]
  4. Adding bond investments to a stock portfolio.
  5. Adding a AAA bond to a portfolio of AAA bonds. [Correct Answer]

Explanation:

  1. Add an international stock investment to an international stock investment – similar expected returns.
  2. Add an international developed stock investment to an emerging markets stock investment – lower expected returns (along with lower expected volatility).
  3. Add an emerging markets stock investment to an emerging markets stock investment – similar expected returns.
  4. Adding bond investments to a stock portfolio – lower expected returns (along with lower expected volatility).
  5. Adding a AAA bond to a portfolio of AAA bonds – similar expected returns.
Disclosures

Insurance vs. Diversified Stocks

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Quiz!

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks.
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Insurance vs. Diversified Stocks

The table below presents a basic comparison between diversified stocks and insurance. The first two rows show similar benefits, while the remaining rows show where each approach shines.

Topic Diversified Stocks Insurance Comments
Distribute risk at any point The growth of 1,000 stocks overshadows one company’s bankruptcy. By pooling 1,000 homeowners, the premiums paid cover the cost of one flooded house. Both help diversify risks at a given instant.
Distribute risk over time The growth of stocks over a full cycle overshadows the decline periods within the cycle. The premiums paid by a large group of homeowners over time cover hurricane damages to a large group of homeowners. Both help diversify risks over time.
Devastating risks House burns down without big money saved => bankruptcy. House burns down => covered by insurance. Insurance is critical for covering risks that would devastate you.
Non-devastating risks Can sell from stocks to cover the low risks. Otherwise, the saved insurance premiums that are invested in stocks are likely to grow dramatically over a lifetime. The insurance premiums are lost. Stocks are typically more beneficial for risks that are not devastating.
Availability The money is available for you at all times, without being at the mercy of an insurance company, but the value will be lower during stock declines. Claims can be declined for various reasons. Insurance: Read carefully the exclusions list for insurance, and have money set aside for declined claims.
Stocks: Have plenty more than the self-insured amounts, to account for stock declines.
Negotiated pricing Not applicable This applies for some types of insurance. Health insurers negotiate lower prices. You get negotiated healthcare costs even with high deductible health insurance, in case this item tips the scale for you.
Risk of under-treatment Risk of avoiding treatment that would otherwise be covered by insurance. Having low-deductible health insurance can encourage treating high-risk problems that seem minor at first If choosing self-insurance using stocks (e.g. by having high-deductible health insurance), be careful to not avoid necessary treatments that you would get with low-deductible insurance.
Overhead No overhead Insurance involves administrative costs and profits to the health insurer, that you pay for. Unless you are a high risk person for using the insurance, your overall average cost may be higher with insurance.

Quiz Answer:

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks. [The Correct Answer]
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Explanations: Read the article for explanations.

Disclosures