A long time ago, I received an interesting comment on my blog.

The reader posed the idea that diversifying your investments is like taking out an insurance policy.

That might sound odd, given insurance and investments are two very different things, but I could see what he was saying. And after you read this article, you will too.

In fact, there’s a few interesting ways to look at this idea, and some useful takeaways for long term investors. It probably won’t change what you’re doing, but it will give you a new way to think about index funds, diversification, and your investing in general.

How diversification is like insurance

As most readers will know, individual stocks can be quite risky. Companies don’t last forever, and many will eventually go bankrupt.

So, taking a diversified approach by using vehicles such as index funds is a way to lower your risk and avoid a disaster scenario. In this way, you’re ‘insuring’ yourself against the risk of relying on specific companies – instead, taking a long-term bet on the market as a whole.

Makes sense, right? So far, the insurance analogy is holding up. Let’s continue with this theme.

What about diversifying between countries? This also has the effect of reducing our reliance on one particular country. By owning international shares, we’re ‘insuring’ ourselves against the risk that Australia doesn’t do well over our investing time horizon (which is hopefully many decades).

If one country has poor long-term returns, which is totally possible, diversifying will improve the average outcome for an investor and avoid a disaster scenario. Again, the similarities between insurance are holding up. We can even extend this a little further.

If we’re able to diversify between asset classes, we can once again reduce our risk on a particular asset class doing well. And in doing so, ‘insure’ ourselves against the chance that it doesn’t. But there’s an important distinction here…

We can’t just diversify between any asset classes. To receive the full benefit, without diluting our long-term returns, we must diversify between asset classes which have similar long-term return expectations. In my view, that means shares can be paired with real estate, which can both be impressive long-term growth assets.

If you pair shares with cash, or bonds, or another asset with lower expected returns, it’s not the same. You’re getting diversification, yes. But in all likelihood, you’re diluting your long-term outcome.

The major difference between diversification and insurance

What I’ve been describing tells us that diversifying our investments has many similarities to insurance.

But there’s one major difference. Have you noticed it yet?

The three forms of diversification I’ve discussed all ‘insure’ against a poor long-term outcome ruining our financial plans. Just like insurance. But insurance comes with something else: a cost.

To be more specific, I’m talking about a negative expected benefit. Let me explain.

When we take out an insurance policy, there’s a strong likelihood that we’ll receive less money back than we’re paying out. That’s just how insurance has to work. Otherwise, there’d be no money to pay for all the insurance staff, brokers, offices, equipment, and make a return for shareholders.

Now, there are some not-for-profit insurance organisations. But even after paying for claims, these firms still have to cover all of these other costs. And most still want to have surplus leftover to reinvest so they can offer more products and improvements in the future. So the maths doesn’t really change.

This is very different from diversifying our investments. Our examples above do not take away from our expected long-term returns. In fact, it often improves our expected return.

Index funds = ‘Insurance with benefits’

You may have heard it before, but most companies in the market don’t beat the index. Over time, the index is driven higher by a relatively small group of huge long-term winners. I wrote about this here. That’s where a good chunk of the value is created.

Unfortunately, these winners aren’t obvious in advance (I know, bummer). In reality, this means that by increasing the number of stocks in our portfolio, we actually improve our returns. Not always, because there are exceptions, but potentially more often than not. That’s why you’ll see it’s so hard for professionals with smaller portfolios to beat the market.

When we invest in different markets and asset classes, we may not necessarily improve our total returns, given these are often expected to have similar long-term performance. But we do improve our ‘risk-adjusted returns’. Basically, we boost the probability that we get the healthy long-term return we’re hoping for.

So again, this is a positive expected benefit, rather than insurance which we should expect to lose from, on average. Now I know insurance has great psychological benefits, and that’s why many people load up on it. But diversifying our investments has that covered too, because we can invest with greater psychological certainty towards our long -erm goals.

I don’t mean literally like insurance…or do I?

When you think about it, our investments (and wealth in general) is kind of like a giant umbrella of insurance. It’s there for us to cover against life’s problems. This pool of money becomes its own form of income protection, disability cover, health insurance, and many other things.

Plus, to stretch the comparison a little further, investments will provide you with a growing source of income and returns, whereas insurance will cost you increasing sums of money over time.

Now, I’m not saying you don’t need any insurance. But it’s worth noting that as your wealth grows, your need for certain insurances reduces. The list of things you can afford to ‘fix’ yourself gets longer.

That said, many still prefer the psychological benefits of having policies in place for each thing, so they don’t have to touch their investments should something happen. On average, this tends to be less profitable than investing the same money, but it does help people sleep at night so it’s totally valid.

And to be clear, I’m not saying diversification protects you from everything. Of course not. There are no guarantees in investing. I suppose there are no guarantees in insurance either, unfortunately. We always like to think we’re covered, but there are those ‘grey area’ claims or loopholes where a policy provider is refusing to pay (or at least trying to wiggle out of it).

Risk and return

Diversifying is not a wimpy, low-risk approach to investing.

In the share market, it’s actually an incredibly smart and efficient way to go about improving your expected returns.

Obviously, if you’re an investing genius, or someone who can beat the market through trading or clever stock picking, then you’ll no doubt disagree with that statement. But for the majority of average investors, myself included, it’s true.

Some would say that diversification reduces your risk and therefore you sacrifice return. But I think it’s more accurate to say it reduces your ‘potential’ return. Meaning, it stops you from achieving (rare) shoot-the-lights-out type returns.

Diversification can be considered the only real ‘free lunch’ in investing.

Final thoughts

There are many similarities between index funds, diversification and insurance. But one side provides an expected financial benefit, while the other we should expect to lose, on average.

To sum up, ETFs and index funds insure us against the risk of individual companies. Diversifying between countries and asset classes can insure us against the risk of either one doing poorly over time.

As we diversify between investments which have equally solid long-term return outlooks, we improve our chances of hitting our goals and achieving a good outcome. The only cost (aside from the risk inherent in any investment)? We lose the ability to earn outsized returns from a higher risk approach.

Given the unlikelihood, that’s a tradeoff I’ll happily take. And I’m sure many of you would too. I hope you enjoyed this article and it helped you think about your investments through a slightly different lens.

Until next time, happy long-term investing.

Dave