Now that we’ve established the importance of minimizing systematic and unsystematic risk, let’s discuss the upside associated with risk: larger payouts over time. First, it bears repeating that you will typically make more money from stocks than bonds. There is “equity risk” in owning stocks, but over long periods of time (e.g., twenty years or more), you can expect a higher return.
Second, small companies are riskier than large companies, but the payoffs associated with the successful ones are much higher than the returns from large companies. Similarly, companies with less liquid capital (so-called “value investments”) tend to yield larger returns than financially strong companies.
When diversifying a portfolio, invest in assets with negatively correlated price movements so that when one goes down, the other has the potential to offset it by increasing. By choosing assets that are unrelated or negatively correlated, you can protect your overall portfolio from the risk of being harmed by unpredictable events.
Nobel Prize-winning economist Harry Markowitz, Ph.D., showed that it’s possible to have two assets that look volatile individually, but when combined in a single portfolio, reduce volatility and increase the potential rate of return.
In investment terms, if you have a Large U.S. Stock portfolio, all in the S&P 500, your portfolio will be vulnerable to risks affecting the U.S. economy. But it’s possible to reduce your level of risk without reducing your potential returns if you diversify further. By blending many individual investments into a portfolio, you create an overall portfolio that is less risky than its individual elements and can even yield greater returns. You could accomplish this by selling off some shares of U.S. funds and purchasing Small International Stocks. Large U.S. Stocks and Small International Stocks are not highly correlated so combined they reduce risk in your portfolio.
The simplest way to enjoy these benefits is by buying into low-cost, well-diversified mutual funds.