diversification is to investing as it is to
everything else in life
controlling the overall risk profile
Volatility
Diversification helps reduce the volatility exposure to any single company, sector, or region, allowing your portfolio to withstand hits from poorly performing investments. Additionally, a diversified portfolio mitigates market entry point risk. Every investment moves up or down by different magnitudes and sometimes in opposite directions. Entering an investment early in an upswing market is advantageous, but being too late in an upcycle can be detrimental, and timing your entry point is difficult, if not impossible.
A well-designed diversified portfolio incorporates a mix of volatile investments that, over time, should produce both capital appreciation and consistently accumulate and compound dividend income.
Time
Time is your best friend in markets and, in many ways, the mirror to volatility. They work in concert but as opposite factors. The rule of thumb for portfolio construction is: with more time, there should be more exposure to volatility, and conversely, with less time, there should be less exposure to volatility.
As asset classes fall in and out of favor, a longer time horizon allows investments to fully realize their potential. This is why longer-duration assets that are relatively more volatile are suitable for portfolios with longer time horizons. Conversely, the shorter the time horizon of a portfolio, the more its asset selection needs to focus on lower volatility investments.
Selection
Time and volatility affect investments differently. Each investment has its own unique volatility profile, which needs to be embedded in a portfolio with the time to manage and extract its value. This is why asset class selection, or rather volatility selection, is often determined by investment time horizons.
For shorter-duration portfolios, investment selection must focus on assets with less volatility. Conversely, for longer-term portfolios, asset class exposures should incorporate more volatility to expose the portfolio to higher potential returns.
Goal
The goal of investing, as opposed to speculating or trading, is to outperform the effects of inflation and the erosion of purchasing power and enable the portfolio to benefit from the productive expansion of a capitalistic economy over the long term. This should be achieved in a manner that aligns with the investor's risk tolerance and goals.
