We can learn a lot from this simple example. First let’s look at the three individual asset classes: US Stocks, International Stocks, and US Bonds. From looking at these three boxes on the graph, we can logically conclude that in order to achieve a higher return, we must take on more risk. International stocks, for example, offer the highest average return but also the highest risk, while US Bonds offer the lowest average return and the lowest risk. We should also recognize that a rational investor wants to move up and to the left on this graph (higher return and lower risk).
Most US investors own a large proportion of US Stocks,1 so they are closest to the red box on the graph. Let’s start there. Now if we diversify our 100% US stock portfolio by adding International Stocks and US bonds, we go from the red box to the blue box. What’s so special about the blue box? We’ve just increased our expected return and lowered our risk!
This diversification effect is possible because different asset classes don’t move in lockstep (their returns aren’t perfectly correlated); sometimes when US Stocks zig, International Stocks and US Bonds zag. It makes intuitive sense that owning multiple asset classes smoothes out the pattern of returns, thereby reducing the risk of the portfolio as a whole. But the part that people tend to miss is that diversification can also increase a portfolio's expected return! By adding risky, non-correlated assets to your portfolio, you can simultaneously increase your expected return while lowering your overall risk.