Skip to navigationSkip to main contentSkip to right columnADVERTISEMENTAllan RothMon, June 15, 2026 at 2:00 AM GMT+2 5 min readConcerned about an AI bubble? Sign up for The Daily Upside for smart and actionable market news, built for investors.Clients often ask about a particular stock or what the next hot stock sector will be. (My response is always a rendition of: “I don’t know the future and neither do you.”)Luckily, arithmetic is much more foreseeable, however, and we know that investors as a whole will earn the market return minus costs. Nobel laureate economist Harry Markowitz coined the concept of “the only free lunch,” meaning that diversification is the only way to reduce your portfolio’s risk, without simultaneously reducing its expected returns.My take is that diversification is even better than a free lunch.Sign up for The Daily Upside at no cost for premium analysis on all your favorite stocks.READ ALSO: Fidelity Joins BlackRock, Vanguard in Offering Annuities in 401(k) Plans and Retiring Advisors Push M&A Deals to $2.5TThe Theory of DiversificationDiversification is so valuable using a very simplistic example (that I used to present when I taught investing.) Let’s say there were two companies: Rainy Day Umbrellas (RDU) and Sunny Sunscreen (SSI). A further simplification is that a year is either sunny or rainy and there is a 50% chance of either. In a sunny year, RDU doesn’t sell many umbrellas and declines by 10% while SSI gains 30%, selling a lot of sunscreen. In a rainy year, the opposite happens. You will invest for two years. If you pick one stock, on average you will be right one year and wrong the other. Your expected return is (1.3 x 0.9) – 1 or 17%. The average annual return (known as the geometric return) is 8.2%. It doesn’t matter if you were right the first or second year, only that you were right one year and wrong the other.Now, instead of picking one stock, say you put half in each. You would earn a guaranteed 10% return each year as one stock would lose 10% while the other would gain 30%. After the first year, you rebalance so that half of your proceeds are back at each stock. You will again get a guaranteed 10%. Over the two-year period, you get a 21% return (1.1 x 1.1) -1. You earn 21% instead of 17%, or four percentage points more.A couple of things to note before we leave theory land. First, the arithmetic average return for the two years is 10% whether you diversified or not. Second, the total returns (also known as geometric) were very different in that the lower amount of volatility (in the second case, zero), the closer the geometric return was to the arithmetic return.Back to RealityIn the example above, diversification not only reduced the volatility, it increased the total returns. It was beyond a free lunch in that you actually got paid to eat that delicious meal. In reality, of course, no assets (I know of) have both an attractive return expectation combined with a negative one correlation. But asset classes with lower correlations can both decrease risk and increase expected returns. You may not get paid as much as the four-percentage point increase in returns (21% vs. 17%) but you do get paid by lowering volatility from diversification.Terms and Privacy PolicyPrivacy & Cookie SettingsMore Info