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Building Your Portfolio

By David Luhman on Mon, 05/11/2009 - 23:24

Building Your Portfolio

The best way to increase your return and reduce your risk

How 2 + 2 = 5

Uncorrelated assets

The best way to build a portfolio

The best way to increase your return and reduce your risk


  • Across asset classes
  • Within asset classes
  • And over time

But by investing in the entire stock market, rather than an individual stock, you enjoy the same average return with much less volatility

How 2 + 2 = 5

An example of diversification

The farmer in the desert

Weather will either be rainy or dry

50 percent chance of either kind of weather

Three locations where the farmer can choose to plant

  • Low valley - crop wiped out if rainy
  • Mid-plains - always safe, but sub-par yields
  • High plateau - crop wiped out if dry

Table of crop yields for various combinations of weather and planting location


Bushels of grain yielded

Rainy season Dry season
Low valley 0 10
Mid-plains 4 4
High plateau 10 0

Best planting method

Planting all in "safe" mid-plains yields only four bushels

Diversify your planting to get a guaranteed five bushels

Plant 50 percent of seed in low valley and 50 percent in high plateau

Seed at one location is wiped out, but seed at other location yields five bushels

It is possible to invest in securities that are individually risky but are not risky when the portfolio is taken as a whole

Uncorrelated assets

You can't just blindly split up your assets and hope to reduce your risk

The key in the above example is to find assets with good returns and are uncorrelated

High plateau and low valley both offered much higher returns than the mid-palins

Planting half in the low valley and half in the low valley a few miles down would still lead to disaster because the locations are related or correlated

Both will be flooded with rain

Likewise if you invest half your money in GM and half in Ford, you won't reduce your risk very much

Better yet, invest your money in GM, General Electric, Wal-Mart, Nippon Telephone & Telegraph and US Treasury bonds

The best way to build a portfolio

Build your portfolio by investing in uncorrelated funds that have good long-term returns

You want good long-term returns, and for one asset to zig when the other asset zags

You could try to switch between assets to always be in the asset that's zigging up and out of the asset that's zagging down, but in practice this switching is very difficult

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