If the expected return from two similar stocks is the same, how should an investor decide in which one to invest? The best answer is she shouldn’t. In most cases, the wiser choice is to buy some of each. The two investments will offer the same theoretical expected return but with lower overall risk.
This same logic applies to sectors of the economy. Should I invest in a diversified group of consumer staples companies or a broad set of industrials? Again, the better answer is to divide the investment among both.
Will the stock of a broadly diversified portfolio of U.S.-based companies do better than a similar grouping of non-U.S. firms? Nobody can know in advance but you can reduce risk by investing in both.
And so on…
Expected returns are related to asset class rather than individual members of the class. Understanding that fact leads to realizing that broad diversification is a wiser investment decision than narrowly choosing among a group of similar investments. Happily, in recent years the financial industry has provided ample vehicles for making such investments at extremely low cost.
Taken to its logical conclusion, this makes the case for the broadest possible diversification using low cost index funds. You want to own a thin slice of “everything” and pay as little as possible to do so.
Of course, different asset classes carry different levels of risk. It is always of paramount importance to avoid a greater level of risk (and volatility) than you can handle. That, however, is a separate topic for another day. Today’s lesson is this: very broad diversification will lower investment risk without lowering expected return. As I wrote in Negotiating Your Investments, that’s a free lunch! And a free lunch is, as the saying goes, as good as it gets.