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Diversification is The Only Free Lunch in Investing

It's been said that diversification is the investing equivalent of a free lunch. The research suggests that not only is it the best way of managing risk but over the long term it also leads to higher returns.

The good news is that index funds and other passively managed investments have diversification built in.

Smart investors believe in index funds because you can very cheaply get exposure to a very broad array of industry sectors, geographies and jurisdictions without really doing much yourself.

This method is better than buying individual stocks or even picking individual industries or countries.

We always hear about investors who bought just the right thing at the right time but they’re in a tiny minority.

You may get lucky but why take the risk of being unlucky?

Take the example 20 years ago, if you had picked the market that was in vogue at the time, namely Japan, you would have lost 75 or 80 percent of your money.

If you had picked the whole world which is what I advocate doing, you would have diversified the risk away of being unlucky in picking just one country, in this case Japan.

This is the age of globalisation markets. Different parts of the world are more closely correlated than they were before.

So have the benefits of diversification lessened?

The short answer is yes because companies are now more global.

Take, Google. They operate in every country in the world, as do McDonald’s and Phillips and all the other big companies.

20 years ago, you couldn’t do this. You could buy in the US, some countries in Western Europe, perhaps Japan.

All these other diversifying markets were simply not available to you. Now they are.

Just like back then, index investments like Vanguard were just really beginning to increase in size but even back then they only had the US markets.

Now they’re global.

Make those the benefits you can gain from.

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