Chart of the Day: More Investments = Less Risk (To a Point)

Today’s Chart of the Day spotlights an important investment concept which was pioneered by Harry Markowitz, a Nobel Prize winner and pioneer of the Modern Portfolio Theory in 1952. 

The theory is: "The higher the number of investments equals lower risk."  However, with each additional investment, the benefit of lower risk goes down to the point that it becomes de minimis (or negligible).  

Imagine the large reduction in risk by adding a second investment to your first vs. adding one more investment to a portfolio of one hundred investments.  

The risk that can be “diversified” away by adding additional investments is called unsystematic risk (in the light blue.) These are risks specific to an individual company, such as bad management, unpopular products, or increased competition.  

The risk that can’t be diversified away is called systematic risk (darker blue). Systematic risks are things like war, inflation, and changes in interest rates which affect all investments, no matter how many investments you have. 

The key take away is that there are only two “free lunches” in investing: lower fees and the ability to reduce your risk from diversification.

Why the "free lunch" for risk reduction? Since it is so easy to do, the market assumes you have already done so, and if you haven't, then you'll end up paying more than you should and due to higher investment losses, end up with lower returns.