I once had the privilege of doing an interview with the Nobel Prize-winning economist William Sharpe at his California home, in which we discussed the finer details of academic finance. But the final question I put to him was a simple one: what is the golden rule of investing?

"There is a rule in real estate," Sharpe answered, "that the three most important things are location, location, location. My rule in investments is that the three most important things are diversify, diversify, diversify."

It was, in fact, another Nobel laureate, and a contemporary of Sharpe, Harry Markowitz, who first established the importance of diversification in investing in his famous dissertation Portfolio Selection in 1952.

Until then, financial professionals had assumed that the best investment strategy was simply to choose a selection of securities that were thought to have the best prospects. Markowitz showed that far more important than the individual securities within a portfolio was the portfolio itself, and, specifically, the extent to which the performance of those securities correlated with one another.

"A good portfolio, Markowitz wrote, "is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies." More memorably, he later described diversification as "the only free lunch" in investing.

This approach to portfolio construction became known as Modern Portfolio Theory. Up to this day, more or less all portfolios have been built, at least to some extent, on MPT, including our own range of portfolios at Index Fund Advisors.

But, to borrow the phrase that Markowitz used, what specific protections and opportunities does a well-diversified portfolio provide? And how do we at IFA decide what to include and what to leave out?

Protections

Let's be clear: all investing entails risk, and diversification certainly doesn't eradicate risk entirely. But the good news is that it doesn't matter. Why not?  Because, if you want your investment to grow, you have to accept risk. Indeed, risk is what drives equity returns.

As Mark Hebner explains in Step 11 of his book, Index Funds: The 12-Step Recovery Program for Active Investors,, trying to avoid risk, as some people do, is futile. "Avoiding risks," he writes, "positions investors to avoid returns."

What diversification does protect you from is concentration risk, or non-systematic risk. This is risk that is specific to a particular security or industry. There have been plenty of examples of well-known U.S. companies that, for whatever reason, went bust (think of Enron, for example, Lehman Brothers or General Motors). We've also seen major industries suffer severe declines — textiles, mining, steel and tobacco, for instance.

Concentration risk is a problem for bond investors too. In the last few years, firms like Hertz, PG&E and J.C. Penney have all defaulted on bond payments. Sometimes entire countries have defaulted, including Russia in 1998, Greece in 2012 and Argentina in 2001, 2014 and 2020.

Each of these episodes caused heavily concentrated investors to suffer serious losses, and yet globally diversified investors were barely affected by any of them.

What diversification doesn't protect you from is systematic risk, which refers to the risk to the entire market. Stock market crashes and corrections are an inevitable feature of equity investing. Bear markets can last for a long time.

Unfortunately, there is no protection from systematic risk. Market timing, or trying to work out when markets are about to peak or bottom out, is almost impossible to do on anything like a consistent basis. So, when markets fall, all investors are affected to some degree or other.

Because there's nothing you can do about systematic risk, your only option is to accept it. Try to see it as the price of your ticket to the world of investing.

Remember, you're going to be investing for a long time. If, say, your time horizon is 20 years or more, you are bound to see at least one major downturn, and perhaps several of them. But what financial history tells us is that, time and again, markets eventually recover, and disciplined investors who refuse to panic and simply stay invested, are rewarded in the long run.

Take a look at the chart below. It lists 18 events since 1929 which caused stock markets to plummet. Investors who acted on their emotions and either reduced their exposure or sold their stocks altogether turned paper losses into actual losses. Many were so scarred by the experience that they stayed on the sidelines for years. But, in every single case, markets recovered their losses and went on to reach new heights, and the investors who earned the highest returns were those who simply carried on investing regardless.

In fact, you should view long-term investing as an extra layer of diversification — diversifying across time. "When investors maintain a globally diversified portfolio for long periods of time," writes Mark Hebner, "they create double diversification across the two dimensions of assets and time. As a result, they are able to maximize their ability to capture the complete range of returns that are offered by the global markets."

Opportunities

As Harry Markowitz showed, diversification doesn't just reduce risk; in the long run, it also increases returns by giving investors access to a wider range of investment opportunities.

The scale of those opportunities is vast. One of my favorite illustrations from the Index Funds book is the one below. It shows a hypothetical stock certificate in a company called Capitalism, Inc., which represents publicly listed companies around the world. The figures are based on a market breakdown provided by Dimensional Fund Advisors from the fourth quarter of 2021. At that time, Capitalism, Inc. would have had a total market capitalization of $77 trillion, more than 14,000 CEOs worldwide, and almost 69 million employees selling products in 195 countries.

Just think about that. When you invest in a globally diversified portfolio of index funds, that's what you're investing in!

But although every investor should diversify, that doesn't mean you should be equally exposed to every investment opportunity out there. That's because the rewards for taking certain types of risk are higher than they are for others.

A common mistake that investors make is taking the wrong kinds of risk. Several asset classes have had relatively high risk and relatively low return. For example, growth (or glamor) stocks, commodities, private equity, long-term bonds, small growth stocks, and technology stocks have all failed to maximize returns for risks taken. Generally speaking, these are risks that are not worth taking.

So what sorts of risk should investors take? Here at IFA, all of our portfolios are constructed using independent, peer-reviewed and time-tested evidence. The aim is to give investors optimal exposure to what are called risk factors, or specific types of securities.

Academics Eugene Fama and Kenneth French have identified several different risk factors. The first risk factor is the market risk factor, or the amount of an investor's exposure to the overall stock market compared to relatively risk-free investments, such as short-term Treasury bills.

Fama and French have also shown how, over time, stocks with particular characteristics — particularly U.S. small companies and U.S. value companies — have outperformed the broader market, albeit with a higher level of risk.

Similarly, longer-term bonds are riskier than shorter-term bonds and, in the long run, have yielded higher returns. Bonds of lower credit quality are riskier than those of higher credit quality and have thus yielded higher expected returns.

The Most Important Decision You Can Make

Finding just the right asset allocation, or optimal risk exposure, is critical. As Mark Hebner says, "asset allocation is the most important determinant of a portfolio's expected return," and, therefore, "it is essentially the most important decision an individual investor can make."

But the right blend of investments will be different for everyone. That's because we all have different capacities for risk, depending on our time horizon, our attitude towards risk, the investments we already have, the income we earn, and our level of investment knowledge.

So why not work out your own unique risk capacity now? Just click on this link and answer a few basic questions, and we'll provide you with your personal risk capacity score.

We can then build a diversified portfolio that's tailored to you, that will protect you from unnecessary risk, and that will put you in the best possible place to benefit from a world of investment opportunities.

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.