Transcription
The real question for me was what would the marginal benefits of diversification like how would you know what is that going to look like? Okay. And what I then decided to do was to think about word risk and the number of sample size and the correlation of the bets, broke it down to its each of its components, right? So to use an example, let's assume you have, make it simple, a return, something that has a 10% risk, we'll call risk standard deviation. And let's make it simple and let's say it had a 10% return. And let's say I add in another asset, another return asset, return stream. I add in a second, a third, a fourth, a fifth, up to whatever number. How would that reduce my risk if it on average has a 60% correlation, or if it has on average has a 40% correlation, or a zero percent correlation? How would that change? Wanted to know that, right?
So that's what this chart shows, right? And so, hmm, so imagine you have a 10% average return, you don't know which bet is going to be better. Has a 10% average return and a 10% risk. And you add in a second and a third and so on. You're not going to lose the 10% because you're still going to have that 10% return. But you're going to then have a reduction. And that's the reduction in risk. And if it has a 60% correlation and you have three or four, you will get a reduction that maybe is about 15%. And you could add in a thousand if there's 60% correlated and you're not going to reduce your risk much, okay? That's important.
Now if I look at that, how that changes according to the levels of the correlation, I start to think, well, what would happen if I added in something that had a 10% correlation by way of example? Okay. Now that's what that line shows, okay? And it shows how much, okay? At about 7 or 8 or so, I cut my risk in half. That means I've doubled my return relative to my risk, right? Oh, that's good. So as I go down this, I then start to understand what the power of diversification is in terms of the things that I'm going to look for.
So what that taught me is the magic is in only, you only need to do this simple thing. The simple thing is to find 15 or 20 good uncorrelated return streams, things that are probably gonna make money, but you don't know, but they have a good probability of making money. And that, but you have that are uncorrelated, that have low correlation. That told me that's what I have to go after, right? That's the key. A lot of people think that the most important thing you could do is find the invest investments, okay? That's important, okay? But there is no great one best investment that can compete with something like this.
So look at this line. When this comes down, you can improve your return to risk ratio by a factor of five, by five times the expected return for that unit of risk. You can't pick any investments that are, probably nobody's humanly capable in an efficient market, probably, to pick investments that are five times as good individually. But so that bad. So it tells me about the power of diversification and balancing risk. So this is the return to risk ratio that happens for each one of those. You know, like if I can get zero correlation and I have 15 to 20, I'll have an information ratio, a return to risk ratio of 1.25. That means my probability of losing money in a year is only 11%, okay? As this thing from 40% with any one of us. So that's the power of portfolio construction and the power of diversification, okay? So it tells me what I have to go after. [Music]