HOW DIVERSIFICATION WORKS

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dadlanirenu
Published
How Diversification Works
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5 Simple Fact:
1) if you have $100k & you lose 50%, you now only have $50k
2) to get back to $100k, you need to make a 100% return
on the $50k
3) asset prices tend to outperform cash over time:
1) growth
-stocks real returns due to productivity
-bonds can collect interest above inflation
-commodity use move up the value chain or get used up,
& prices get bid up
2) inflation
-stable stocks hold onto value during inflation
-bond rate = inflation rate + real interest rate
-commodity price go up a lot during inflation
4) all assets can go down 50% & even stay there for years
5) prices are effectively random quantitatively even with AI

Given This, How Can We Outperform?
1) Information Edge - Very Hard

2) Save more (earn more & spend less) - Moderately Hard
3) Pay less in taxes (long term capital gain) - Sort of Easy
4) Diversify across asset classes using ETFs - Trivial

Simulation Parameters:
Equity: 10% return 30% stdev
Commodity: 8% return 30% stdev
Bond: 5% return 10% stdev
Cash: 3% return 3% stdev

Observations:
1) lines with same exact EV underperformed a diversified one
2) a combination of lower EV assets outperform the best EV
asset with lower volatility in simulation
3) it also does so in practice
4) 25/25/25/25 is conservative, but 33/33/33 leads to slightly
higher returns with higher volatility
5) tax doesn't matter much in retirement accounts since
multiplication is commutative
6) outside of retirement accounts, you want to rebalance
as little as possible
Category
Crypto Trading
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