By this stage (as in, now that you’ve read part 1), I hope you’re pretty sure that there’s no free lunch, and that great return usually comes with great risk. But there’s more to the world than just Lisa and Henry, and that’s great news for all of us, because there is one almost magical way to reduce a fair amount of risk without sacrificing too much reward. Diversification. Yet another high finance topic that I think you’ll find you already understand.
So. Let’s say you decide to lend money just to Henry, or even just to the “safer” bet, Lisa. Either one still leaves you at the mercy of an unexpected heart condition or a fast-moving bus. In an instant, your investment can be wiped out by a singular event that comes out of nowhere – lightning strikes and plane crashes weren’t in your model.
With that in mind, you might be better off lending to both of them. Or, better yet, you lend it to lots of different people.
Lending to Lisa, Liam, Mary, Mark, Misha, Harriet and Henry stretches you across a wide range of riskiness (and returniness), while making it extremely unlikely that they will ALL meet with sudden tragedy (not impossible, just very unlikely). You’d have to be very unlucky.
That is diversification. Spreading your money across MORE different things so there’s LESS risk of you losing your money.
Bear in mind that investing in many things that are very similar does not bring the diversification I’m talking about. If Henry, Harry, Hugh and Herbert are all entrepreneurs at the same start up incubator developing the same sort of app, and they all go out drinking together and fly in the same airplanes… you haven’t diversified your risk much at all.
MOST IMPORTANT DISCLAIMER EVER: even if you do it right, you can’t diversify all your risk away – infinite diversity does not bring about zero risk. It just helps REDUCE risk.
In the real world, there’s more to investing than lending money to dentists and entrepreneurs. Portfolio managers make Lisa / Mary / Henry decisions all the time when they decide which shares to invest in.
A single share will move up and down, will have a certain amount of risk, will rob you of a certain amount of sleep (or not).
But a collection of diverse shares creates a tangle of diverse stories, and that turns into a sort of ‘white noise’. That rollercoaster roar of individual share performance dulls to a hum – to a somewhat more stable, diversified portfolio return over time:
Portfolio managers work hard to maintain diversified portfolios, in large part so that the people who entrusted their savings to them aren’t traumatised by wild swinging gains and losses. That relative calm amidst all the noise – that makes investing less of an emotional and financial rollercoaster ride – is the big benefit of diversification.
Photo by: Edwin Torres, Various dice via Flickr, CC by 2.0.