Wall Street investors often say “diversification is the only free lunch”, meaning that having a diverse mix of assets in a portfolio can reduce volatility while still producing acceptable returns. Volatility is often equated with risk, reasoning that a more volatile asset or asset class will have more significant variations in price than an asset with less volatility, and therefore be more risky.  Combining assets that are not correlated with one another into a portfolio can therefore be desirable to reduce or manage risk, as long as the returns of the uncorrelated assets are acceptable.

For example, while bonds are generally believed to have lower volatility and to be less risky assets than stocks, a modified portfolio of 75% bonds and 25% stocks is less risky than a portfolio of 100% bonds due to diversification and the lack of correlation between stocks and bonds, the two asset classes in the modified portfolio.  The modified portfolio of 75% bonds and 25% stocks produces a higher return than the portfolio of 100% bonds, though, due to stocks’ historically higher returns relative to bonds.

Similarly, an investor who is OK with the risk of a 100% bond portfolio can enhance overall returns by assembling a portfolio of 50% bonds and 50% stocks, which has roughly the same risk as a portfolio of 100% bonds but substantially higher returns.  Increasing the percentage of stocks further results in even higher returns, but with a risk or volatility greater than the risk of the bond portfolio alone.

These examples illustrate how combining two assets, or asset classes, results in returns that are an average of the returns of the proportionate asset classes, while risk can be reduced to less than that of any one of the combined asset classes alone.  This only holds true for assets or asset classes that are not strongly correlated, though, as it should be no surprise that combining two portfolios having similar volatility and returns that are 100% correlated with one another simply produces a bigger portfolio with the same volatility and returns as the constituent portfolios.

The funds in the model portfolio presented here therefore desirably represent asset classes that are not strongly correlated with one another.  For example, a portfolio of energy, natural resources, energy services, and precious mineral funds or ETFs would be expected to have significant overlap, and strong correlation in price movement between the funds.  The current model portfolio of housing, biotech, and emerging markets dividend stocks does not have any such obvious correlation between asset classes, and is likely to have lower volatility than any of the constituent funds alone.

Because the return of an evenly weighted portfolio of uncorrelated funds is the average of the return of the independent funds, we can therefore produce a portfolio having a return that is the average return of the individual funds while experiencing lower volatility than the average volatility of the individual funds.  Average returns + lower than average volatility = Free Lunch!  The task for the investor remains choosing few enough funds for the portfolio to produce the expected higher returns of more favored asset classes or funds while having enough uncorrelated funds or asset classes represented to reduce risk to acceptable levels.

For the model portfolio, that’s three to four funds not strongly correlated with one another held at any one time, depending on whether four diverse asset classes having expected high returns can be found at the same time.