We’ve all been brainwashed into diversifying, but exactly why is this the best way to invest?
By owning several items that behave differently, our return is the average of these items. In short periods, we know investments can move in a wide range, which is how we typically define “risk.” Though I could argue this point, we’ll save that for another time.
However, if we own several items and earn their average, we will never suffer a loss equal to the worst performing thing we own. Of course, the flip side is that we will never enjoy a gain equal to the best performing item we own.
Instead, we get the average, meaning something will always be better and something will always be worse.
However, the magic is that over a long period of time, the difference between best- and worst-performing items narrows greatly, meaning they both get closer to the average.
So, by diversifying we avoid the chance our portfolio will be the worst in the short run, while preserving our average return in the long run – which will be very near to the best performing item as well!
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