The only free lunch in investing

This is a chart of two ETFs, COMT and VT, representing respectively an index of commodities and an index of the world stock market. But I’m posting it here not to compare investments but to make a point about portfolio construction.

Notice that these two funds have almost the same total return over the past five years. But the distributions of those returns over time were quite different.

An investor could have chosen either one five years ago and ended up with about the same portfolio value today. But by blending the two, say, putting 25% into commodities and 75% into stocks, the returns would have been much steadier and more certain. And if the investor had occasionally rebalanced along the way, the total return of the two fund portfolio would have been greater than the returns of either of its two components. How this works is illustrated in detail in Invest With A Demon.

This view of correlation and diversification is statistically based; that is, it’s based on past patterns of performance. It’s essential to look at it from a fundamental point of view too. What are the sources of performance? For instance, although they occupy different positions in the capital structure, corporate bonds and stocks both depend on the financial health of the same issuers, corporations. This is one reason our model portfolios use only government treasuries for bonds; not only are the correlations with stocks lower but the sources of return are distinct too. The same applies to the stock and commodity funds we opened with.

A good investment portfolio is about much more than a collection of good assets … it’s about how they work together. Investors commonly make the mistake of selecting handful of investments all of which they believe will have high returns, without regard for how they interact with and complement each other. But looking for sources of return that have low correlations with each other helped make Ray Dalio one of the world’s most successful investors. Diversification isn’t just for safety … properly executed combining and balancing of assets boosts returns too.

This principle is woven into the Financology Model Portfolios as well. Each of the funds is selected to have investment merit on its own, but the combinations are like recipes. Good quality flour, sugar, eggs and other ingredients are necessary to bake a cake, but too much or not enough of any one, no matter how carefully selected on its own, will fall flat.