We’ve all heard the adage about not putting in your eggs in one basket. This is good advice. But why? The basic premise of investing is to be rewarded for risk that you take. That’s why savings accounts pay you essentially nothing in interest; they are assumed to be very safe places to store money.
That said, it makes sense that you would want to be paid as much return possible for every “unit” of risk. Diversifying does exactly that. Done correctly, diversifying your portfolio increases the per unit return that you receive for every unit of risk. To understand this concept, we need to quickly define three things:
* Expected return — This is the return that you expect to receive for investing in something. Coming up with this value is an entire universe of topics which we will delve into later.
* Standard deviation (a measure of risk) — A statistical measure of volatility. It answers the question “On average, how much different was each year’s return from the long term average?”
Standard deviation is always calculated with historical data… that is, you can look at historical returns and calculate the average return. Standard deviation is the average difference between each year’s actual return and that single average you calculated for the whole time period.