The magic of diversification

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According to Mr Bluford Putnam of EQA Partners, a consultancy, “if we had perfect foresight we would not need a portfolio to control risk” and that’s exactly what a Main Street investor should always bear in mind: diversification.
Portoflio diversification can be demonstrated at two different levels: naive and efficient.

A glance at the chart below should reveal how the former can help lower risk and enhance return, without much ado: by only increasing randomly the number of securities in a portfolio we can achieve more with less (in terms of the trade-off between risk and return). Moving from top to bottom in the plot below one can notice how portfolios consisting of respectively 5, 10, 50 and 100 securities (left column) of the S&P 100 can lower risk and enhance return (right column).S&P 100 naive divesification

The set of feasible portfolios – green dots for 5 thousand of them – moves from right leftward towards less risk, as the efficient frontier – the upper part of the solid line curve – moves upward though the security cloud – on the left column – tends to expand outward to the left and to the right (more risk).

No matter how risky Facebook (FB in the chart at the bottom on the left) but if you blend it in a portfolio you can rest assured it won’t hurt much if moves against you.

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