During times of pronounced volatility (like we’re seeing now), investors often try to find new ways to neutralize how market gyrations impact their portfolios. This can mean selling down stock positions, owning fewer stocks, shifting asset allocations to favor bonds or even looking to new asset classes like real estate.
These tactical changes to investment strategies are almost always reactionary in nature – owing not to changes in market fundamentals, but rather to shifts in personal sentiments. In other words, they’re emotionally driven, which is the exact opposite of what they should be in the investment world.
Diversification is Time Tested, Yet Investors Still Challenge It – Frequently
To me, the most optimal method for neutralizing volatility is the same method I used 20 years ago when I began my investment career: diversifying. Over the years, I’ve come to think of diversification like I do exercise. In spite of all the monumental medical advancements developed over the years, exercise still reigns supreme as one of the best things a person can do to care for their long-term health – it worked just as well 50 years ago as it does today.
Diversification, to me, is precisely the same timeless key to successful investing. It worked just as well 50 years ago as it does today, yet investors regularly abandon it as a strategy at critical times. It’s puzzling.
When the going gets tough in the markets, as it could for a few weeks yet, remember that diversification provides these three long-term benefits:
- Reduces Volatility – since asset classes do not move in lockstep, and leadership amongst regions, sectors, and styles often changes hands, diversifying across them can help reduce volatility while increasing long-term returns. Some positions zig while others zag, and you can create a smoother path by owning both.
- Creates Several Liquidity Options – if you need to raise cash, a well-diversified portfolio can create strategic opportunities for you to do so. You can potentially use outperformers as liquidity sources, and not have to sell underperformers at weak times.
Captures Returns from Different Markets While Limiting Risk from Any One – clients who advocate for owning fewer stocks/positions (see below) often forget a key point: there’s no way to know with certainty if you’re betting on the outperformers. If you concentrate your portfolio in certain areas of the market, sure – you create the opportunity for outperformance, but you also leave your portfolio susceptible to disproportionate downside if you’re wrong.
Isn’t There Such a Thing as Over-Diversifying Though?
I’ve had some clients raise concerns over being too diversified – owning too many positions to the point they believe they are diluting their upside potential. But owning a more concentrated portfolio with fewer positions not only (generally) creates additional risk, it also does not necessarily ensure you will outperform a well-diversified portfolio over time.
Data from a J.P. Morgan study conducted from 1994 – 2012 underscores this point. Portfolio A was invested in just three positions: 55% in the S&P 500, 15% in the MSCI EAFE, and 30% in the Barclays Capital Aggregate (U.S. Bonds). Over that 18 year period, Portfolio A generated returns of 7.43% with a standard deviation of 10.80.
Portfolio B was more broadly diversified, investing across eight asset classes/styles versus the three in Portfolio A. It had 8% in Equity Market Neutral, 8% Commodities, 8% REIT, 22% S&P 500, 9% Russell 2000, 13% MSCI EAFE, 4% MSCI Emerging Markets, and 26% Barclays Aggregate. Investors who don’t like owning too many stocks or too many positions would likely prefer Portfolio A over Portfolio B, citing that Portfolio B would likely dilute returns over time (by virtue of being over-diversified). The opposite held true in fact:
Over the same 18 year period, Portfolio B produced a 7.72% annualized return, with a standard deviation of 9.87. It had more positions, greater returns, and lower risk. The proof is in the pudding.
Bottom Line for Investors
Investors often make changes during volatile times to feel as though they’re doing something about it. But what many don’t always realize is that they are usually just substituting one risk asset (or type of risk) for another. In the case of the investor who sells down equities in favor of holding more cash and/or bonds, they are often unwittingly creating an entirely new type of risk for their retirement: the risk of running out of money.
The bottom line is that, in order to generate the type of long-term returns that most retirees are looking for (equity-like), you almost always have to accept a certain amount of risk…and with that risk comes volatility. The key is not to take steps to avoid the risk altogether, but rather to manage the risk where possible. And historically, the best way to do that has been through diversification.
Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.
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