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the real question for me was what were 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 uh risk and the number of sample size and the correlation of the bets broke it down to it each of its components right so to use an example let's assume you have to 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 Street 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 0% correlation how would that change wanted to know that right so that's what this chart shows right and so 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 they're 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 seven or eight or so I cut my risk in half that means I've doubled my return relative to my risk right o 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 um what that taught me is um the magic is an 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 going to make money but you don't know but they have a good probability 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 best investments okay that's important okay but there is no great one best investment that can comp 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 right 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 path so it tells me about the power of divers ification and balancing risk so this is the return to risk ratio that happens from 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 The Sting from 40% with any one invest so that's the power of portfolio construction and the power of divers ification okay so it tells me what I have to go after
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