If you had invested in the KOSPI index over the past year, you would have earned a return of 75.62 percent. Including dividends, the total return approaches 80 percent. Any investor who, expecting similar high returns, went all-in on the KOSPI this year would have suffered considerable stress amid the recent volatile market. Many investors likely saw their gains shrink or even slipped into loss territory as the index swung sharply in a short period.
Times like these remind investors of the need for diversification. Generally, everyone agrees on the rationale for diversification. Spreading investments across multiple assets reduces risk and allows investors to stay the course with greater peace of mind.
Diversification does more than simply lower risk. Reducing volatility ultimately helps boost long-term returns. This can be explained through the concept of "volatility drag." In simple terms, the more returns fluctuate up and down, the less wealth actually accumulates over the long run.
To elaborate further: the average annual return we commonly see — the arithmetic mean — is not the same as the long-term return that reflects actual investment outcomes — the geometric mean. The greater the volatility, the wider the gap between the two figures, and the lower the long-term return ends up being. Therefore, higher short-term returns combined with lower volatility produce superior long-term performance.
A simple example illustrates this point. Compare a case where an investment falls 5 percent and then rises 5 percent with one where it falls 10 percent and then rises 10 percent. On the surface, both scenarios appear to be a symmetrical decline and recovery. But the actual results differ. The second case, with greater volatility, produces a lower total return. In other words, the bigger the swings, the more you actually lose.
So how can investors maintain returns while reducing volatility? Investing in a single asset leaves no room for such adjustment. The answer is to build a portfolio combining two or more assets. The more differently those assets move from one another — that is, the lower their correlation — the greater the volatility-reduction effect. Holding assets that move in different directions naturally smooths out the overall portfolio's fluctuations.
Harry Markowitz's "mean-variance optimization" theory systematically explains this process. Though the concept dates back to the 1950s, it remains highly significant for showing how combining multiple assets can raise returns while lowering volatility. Markowitz received the Nobel Prize in Economics in 1990 for this contribution. Ultimately, the core message is simple: allocate assets wisely, and you can expect higher returns with greater stability.