Concept Two: Dissimilar Price - Movement Diversification Enhances Returns
If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return. For example, let's assume you are considering two mutual funds. Each of them has had an average arithmetic rate of return of eight percent over five years. How would you determine
which fund is better? You would probably expect to have the same ending wealth value.
However, this is only true if the two funds have the same degree of volatility. If one fund is more volatile than the other, the compound returns and ending values will be different. It is a mathematical fact that the one with less volatility will have a higher compound return.
You can see how this works from Exhibit 3. Two equal investments can have the same arithmetic rate of return but have very different ending values because of volatility. You want to design your portfolio so that it has as little volatility as necessary to achieve your goals.
Exhibit 4 shows two portfolios with the same average return. As a prudent investor, you want the smoother ride of Portfolio A not only because it helps you ride out the emotional curve, but more importantly, because you will create the wealth you need to reach your financial goals.
