Portfolio Forces

What if you could earn similar returns to the stock market without taking any risk? Would you invest in something like that?

Before I go any further with this line of thinking, I’ll go ahead and say that it’s not possible.?As the guys from Mythbusters would say, that myth is BUSTED.

But what if there was a way to earn a similar return to the stock market while taking less risk?

Now that myth is PLAUSIBLE. The underlying driver of this plausibility is diversification.

Consider the title image (also below) which shows a portfolio made up of a variety of assets.

The portfolio starts out moving in a positive direction at the rate of the expected return. The forces of economic growth and inflation then act on the various assets in the portfolio and push or pull the assets in various directions. (Note that the image shows the direction that forces act when economic growth or inflation exceed expectations.)

As the image implies, your actual portfolio return is equal to your initial expected return plus a function of the combined forces of economic growth and inflation. This can be represented by the equation below. We will call the term that represents the function of forces the "force function".

If you only own stocks, your portfolio is going to have unbalanced forces. The force function of a single asset portfolio can be largely positive or largely negative.

If economic growth exceeds expectations and inflation falls short of expectations, your return will probably be great because both of these tend to cause the force function to be positive.?

If economic growth doesn’t meet expectations or inflation exceeds expectations, your portfolio return will likely suffer as these forces tend to cause the force function to be negative.?

Alternatively, consider the portfolio with a variety of assets. If you have a mix of assets that tend to do well in different economic environments, you stand a chance of balancing out some of these forces.?

If you could perfectly balance out all of these forces, you would be able to cancel out the force function term and all you would be left with is your expected return.??

There is no way to find enough diversification to balance out all these forces perfectly. However, as you add more diversifiers that tend to do well in different economic environments, you can minimize the magnitude of the force function term and attempt to earn a more consistent return.