Why Diversification Is Often Misunderstood

Ken Fisher addresses the common misconception about portfolio diversification, explaining that most people expect simple percentage allocations across different assets, but this approach misses the fundamental principle. He references Harry Markowitz's technical definition of diversification, which involves identifying investments with similar long-term return expectations that exhibit inverse short-term price movements. When properly blended, these assets provide the expected long-term returns with reduced volatility along the way. Fisher illustrates this concept by explaining how different types of stocks that don't move simultaneously but have similar long-term performance can create a smoother path to returns. However, he highlights a critical problem with this approach: major asset categories don't actually have similar long-term returns when properly adjusted. Using gold as an example, Fisher notes that while many investors want to include it in portfolios, gold has very high volatility relative to other liquid assets but markedly lower returns than stocks, performing more like bonds. This makes it difficult to pair stocks and gold unless one expects stocks to have lower future returns than their historical 100-year average. Fisher emphasizes that effective diversification is always about identifying assets with high long-term return potential that take different paths to achieve those returns, rather than simply purchasing many different types of investments.