Improving Investment Portfolios with Seemingly Inferior Assets

Imagine you are building a balanced meal, not just for today, but for your long-term health. You know you need protein, carbohydrates, and vegetables. Let’s say you are already including plenty of protein and carbs, which are like your high-performing, well-known assets in the investment world. These are the assets that everyone talks about, the ones that seem obviously good.

Now, consider adding vegetables to your meal. On their own, vegetables might not seem as exciting or immediately impactful as a juicy steak or a bowl of pasta. They might even seem ‘inferior’ in terms of providing instant energy or building muscle quickly. However, vegetables bring essential vitamins, minerals, and fiber to your diet. They contribute to your overall health and well-being in ways that protein and carbs alone cannot.

This is similar to how adding seemingly ‘inferior’ assets can improve your investment portfolio, specifically in relation to something called the efficient frontier. Think of the efficient frontier as the boundary of the best possible investment options. It’s a curve on a graph that shows you, for any given level of risk you are willing to take, what the highest possible return you can expect is, and conversely, for any desired return, what the lowest possible risk you must accept is. Portfolios that lie on this frontier are considered ‘efficient’ because they offer the best risk-return trade-off.

Now, how can adding assets that look less impressive on their own actually push this frontier outwards, making it better? The key lies in diversification and correlation. Assets that seem ‘inferior’ in isolation might behave differently from your already strong assets under different market conditions. Think of it like this: if your portfolio is heavily invested in technology stocks, which are like your protein-rich foods, it might perform very well when the tech sector is booming. However, if the tech sector faces a downturn, your entire portfolio could suffer significantly.

Adding assets that are less correlated with technology stocks, perhaps assets in different sectors like utilities or real estate, or even different asset classes like bonds or commodities, is like adding vegetables to your meal. These assets might not generate the same explosive growth as tech stocks in a tech boom, hence appearing ‘inferior’ in a direct comparison during that period. However, they tend to react differently to market changes. For example, when tech stocks decline, utilities or bonds might hold their value or even increase, acting as a buffer in your portfolio.

This difference in behavior is crucial. When you combine assets that don’t move in lockstep, you reduce the overall volatility or risk of your portfolio. Imagine you have two friends helping you move furniture. One is incredibly strong but only available on sunny days. The other is not as strong but is reliable rain or shine. If you only rely on the strong friend, you are stuck if it rains. But by using both, you have a more reliable moving team, even though the second friend is less impressive on their own in terms of raw strength.

By adding these less correlated, seemingly ‘inferior’ assets, you are not necessarily increasing the highest possible return you can achieve in a perfect market scenario. Instead, you are smoothing out the ride. You are reducing the dips in your portfolio’s value during market downturns without significantly sacrificing potential gains during upturns. This improved risk-return profile effectively shifts the efficient frontier outwards and upwards. You are now able to achieve a higher return for the same level of risk, or take on less risk for the same potential return, compared to a portfolio composed only of those initially ‘superior’ assets.

Therefore, the power of diversification lies in combining assets with different characteristics, even those that might appear less attractive individually. It’s about building a well-rounded, resilient portfolio, much like building a balanced and healthy diet. By strategically adding these seemingly ‘inferior’ assets, you are actually making your overall investment strategy more efficient and robust, pushing the boundaries of what you can achieve in terms of risk and return.