Making Money Simple by Peter Lazaroff

Author:Peter Lazaroff
Language: eng
Format: epub
ISBN: 9781119537854
Publisher: Wiley
Published: 2019-04-02T00:00:00+00:00

FIGURE 7.7 COMBINING INVESTMENTS THAT BEHAVE DIFFERENTLY REDUCES VOLATILITY

Asset Class A (black line) has a return of 20 percent in Year 1, –10 percent in Year 2, 18 percent in Year 3, 25 percent in Year 4, and 5 percent in Year 5. Asset Class B (light gray line) has equally wild returns, but they generally move in the opposite direction of Asset Class A. Combining the two asset classes so that your portfolio holds 50 percent of each generates a dramatically more consistent stream of returns (thick, dark gray line). As a long‐term investor, the goal is to combine investments that zig with others that zag to reduce volatility without sacrificing return.

Diversification has obvious appeal from a risk tolerance standpoint, but you're doing more than just managing risk well: you're allowing your portfolio to compound returns more effectively. The math behind this will really blow your mind. Figure 7.8 shows a $100,000 investment in two different portfolios that each have an average return of 10 percent. At the end of Year 3, investors with the High Volatility Portfolio are probably bragging to their friends about earning more than 20 percent returns in each of the past two years. Similar opportunities to brag surfaces with outsized returns in Year 7, Year 9, and Year 10. But when you look at the end result, the Low Volatility Portfolio ends up with more money.

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