How Diversification Reduces RiskbyJ.D. RothPublished on September 29th, 200929CommentsThis is a guest post from Robert Brokamp ofThe Motley Fool.Robert is a Certified Financial Planner and the advisor for The Motley FoolsRule Your Retirementservice. He contributes one new article to Get Rich Slowly every two weeks.Quick! If you had to choose just three types of assets that should be in a well-diversified, long-term investment portfolio, what would they be?If we polled the Get Rich Slowly audience, wed get a range of responses to that question. However, I think plenty of folks would have answered bonds, U.S. stocks, and international stocks. Which is perfect, because those are the investments in the demonstration ofasset allocationthat Im about to embark upon. (You are all so accommodating!)Lets look at the returns of three mutual funds from 30 June 1989 to 30 June 2009: The Fidelity Intermediate Bond Fund (FTHRX), which holds bonds that mature in five or so years; the Vanguard 500 (VFINX), which very closely mimics the performance of the Standard & Poors 500 index of large U.S. stocks; and the T. Rowe Price International Discovery Fund (PRIDX), which invests in small companies from all over the world.

We can make a few observations about these returns: Compounding is cool.Even by just earning approximately 6% a year, the initial investment more than tripled over two decades. Earn a bit over 9%, and you could almost sextuple your investment (and have fun saying sextuple to your friends). Higher return comes with higher risk.Yes, the T. Rowe Price fund posted the best long-term performance, but its worst years were really worse. You dont always get that higher return.While the Vanguard 500 beat the Fidelity bond fund, that was due to the extraordinary returns of stocks in the 1990s. Over the past decade, U.S. large-company stocks actually have lost to bonds. (In fact, as I wrote over at The Motley Fool, the return on such stocks from 1999-2008 was even worse than the 10-year returnsduring the Depression.) Earning a little bit more can lead to big bucks.The annualized return of the Vanguard 500 was just 1.52% more than the annualized return on the Fidelity bond fund. Yet the difference in the amount $100,000 grew to after 20 years was huge; the Vanguard 500 earned an extra $108,568, 33% more than what an investor earned in the bond fund. Ive said it before, and Ill say it again: Thats the power of earning a little bit more or paying a little bit less over the long term. (It is pure coincidence that the difference between the returns of the two funds, or 1.52%, is very close to the average expense ratio charged by actively managed mutual funds. But its a telling illustration: If youre paying that much annually to invest in a mutual fund, but not getting superior results in return, you could be giving up tens of thousands of dollars.)Lets say you are given these three investment choices for the next 20 years. How would you allocate your portfolio? If youre an aggressive investor, you might put all your money in the T. Rowe Price International Fund. But could you stand such large declines? And what if international small companies dont do as well over the next 20 years?If youre a conservative investor, however, you might go the opposite direction and put all your money in the bond fund. Your portfolio would be nice and steady, likely avoiding sleep-disrupting double-digit annual declines. But, if the future is anything like the past, you could potentially be passing up $100,000 to $200,000 in gains. Perhaps thats playing it too safe.Lets try a simple solution: Investing one-third of the portfolio into each of those funds and rebalancing annually. What do you think the annual return would be?You might pick a number that is the average of the annualized returns on those funds, which would be 7.67%. But here are the actual numbers:

Well, looky there. You got a return that beat the arithmetic average of the three returns. It significantly outperformed the S&P 500, and it did so with a lot less volatility (as indicated by its worst years not being as bad). By owning assets that move in different directions at different degrees and at different times, along with some regular rebalancing, you get a return that beats the average returns of the investments in the portfolio. The whole is greater than the sum of its parts.Sure, that extra return is less than 1% a year. But weve already demonstrated howearning a little for a long time really adds up. And that return beat the return of two of the portfolios three components. AsI wrote in May, asset allocation means you dont have to predict which type of investment will do best which can be dangerous, because you could be wrong.A well-diversified portfolio provides a respectable return, with lower volatility than a portfolio of just one type of stocks.Not a bad deal at all.