I agree with some of the points Matthew is making in his well thought-out comment, but I strongly disagree with others. Clearly, Matthew is right that the longer your time horizon the more aggressive your portfolio can be. This is a basic truth of investing.
"There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon. No discussion of risk and reward is complete without including the impact of time on both quantities.Given a sufficiently long window, there is no reason to invest in anything but 100% equities. Diversifying beyond this asset class would only create a drag on your final return and increase transaction costs.
However, let's make a distinction between risk and expected return. Risk is traditionally measured by the volatility of the asset class in question. Volatility is the relative change in price over time. The concept of risk is strongly related to but is very different from the concept of expected return. Expected return is the amount of money you would receive, on average, over a certain period of time, by investing in that asset class. Let me give an example that will clarify the difference between those two concepts:
The S&P 500 for example has historically averaged a return of approximately 7.3% per year since its inception (not including dividends). If you believe that the S&P will continue to behave as it previously did, your expected return is about 7.3% per year (plus dividends). However, the S&P very rarely yields exactly 7.3%. The return fluctuates. Some years the S&P returns double digit gains, other years investors lose an arm, a leg and one buttock. The S&P (as well as all other equity) is a relatively volatile and hence risky asset class.
Given the option between a volatile asset and a stable asset, both of which are expected to return the same amount, a rational investor chooses the more stable asset. Why accept uncertainty and risk if in the end you expect to make the same amount of money? Think of it this way: if you were able to get 7.3% on a CD, every year, for the foreseeable future, would you invest in the S&P which on average would yield the same return, but could have some seriously down years included in the mix? Of course you wouldn't.
With the concepts of expected return and volatility safely locked in out heads, let's go back to Matthew's comment. Matthew is saying: "There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon". That statement is not correct. By increasing your time horizon you are more likely to achieve the expected average return on the asset class in which you are investing (7.3% in the example we used above), but you are doing NOTHING about volatility.
Let me explain: in any given year the stock market may tank or soar, but if you stay in the market for a large number of years, your chances of achieving your expected return are high. Compare it to a game of heads or tails. If you flip a coin twice, you wouldn't be surprised if it came up heads (or tails) twice. However, if you repeated that coin flip 1,000 times you would expect (and the laws of probability are on your side) that the number of heads and tails will be pretty close to each other. You would be really surprised if you threw heads 900 times and tails only 100 times - although that too COULD happen. This is because the expected outcome of the game is that 50% of the time you will flip a head, and 50% tails will appear. However, the long term expected outcome has absolutely no bearing on the next flip of the coin.
Matthew is confusing volatility with expected return. By expanding your time horizon you are likely to achieve the expected return, over the life of your investment, but that does not reduce the risk that your portfolio will tank in any given year.
Enter diversification: going back to the coin flipping game. Diversification is akin to playing heads or tails with several coins simultaneously. Each coin represents a different asset class in your portfolio. The chances of flipping all tails when using, say, 10 coins simultaneously is vanishingly small. Diversification reduces the volatility of your portfolio, and in many cases it can do so without reducing your expected return. Matthew's statement that "Diversifying beyond this asset class [equity - Shadox] would only create a drag on your final return and increase transaction costs", is simply not accurate. More about this specific point in a future post.
In the meantime, I will let this excellent example from The Sun's Financial Diary, speak for the merits of diversification. I suspect that if diversification beyond equities was not a worthwhile undertaking, a sophisticated investment team such as Yale's endowment managers wouldn't bother with it... 'nuff said.