Basic economic theory dictates that there’s no such thing as a free lunch. Nobel prize-winning economist Markowitz begged to differ – he called diversification “the only free lunch in finance.” But he wasn’t the first to understand the benefits of diversification – long before he came up with the Modern Portfolio Theory in 1952, Shakespeare’s Antonio in Merchant of Venice already eloquently expressed his understanding of the concept:
Believe me, no. I thank my fortune for it —
My ventures are not in one bottom trusted,
Nor to one place, nor is my whole estate
Upon the fortune of this present year.
Therefore my merchandise makes me not sad
Markowitz’s theory is if you hold a portfolio of investments that are not perfectly correlated, an investor can lower risk without sacrificing expected returns. Simply put, spreading your investments across asset classes and geographies gets you the same reward with less risk = free lunch!
Diversification is not particularly exciting, but it reduces the risk of blow-ups due to any single investment. A diversified portfolio will always have a few investments that are not doing so well, a few that are average, and hopefully a few that do great. The thing is – this is random and beyond our control, but if we are diversified, on average we will do just fine. As you can see from the table below of the top ten performing asset classes per year, there is no predictable pattern.