Have you ever ridden in a car with worn-out shock absorbers? Every bump is jarring, every corner stomach churning, and every red light is an excuse to assume the brace position. Owning an undiversified portfolio can sometimes trigger similar reactions.
In a motor vehicle, the suspension system keeps the tires in contact with the road and provides a smooth ride for passengers by offsetting the forces of gravity, propulsion and inertia. You can drive a car with a broken suspension system, but it will be an extremely uncomfortable ride and the vehicle will be much harder to control, particularly in difficult conditions. Throw in the risk of a breakdown or running off the road altogether and there is a real chance you may not reach your destination.
In the world of investments, a similarly bumpy and unpredictable ride can await those with concentrated and undiversified portfolios or those who constantly tinker with their allocations based on a short-term rough patch in the markets. Of course, everyone feels in control when the surface is straight and smooth, but it is harder to stay on the road during sudden turns and during the ups and downs of the stock market. Keep in mind the fix for your portfolio breaking down is unlikely to be as simple as calling in a tow truck. While it has been over 50 trading days since the last 1% daily move in the U.S. stock market, to paraphrase the popular TV show, Game of Thrones, volatility is coming. So plan for more volatility in the markets at some point.
For that reason, the smart thing to do is to diversify, spreading your portfolio across different investments, asset classes and globally. That also means identifying the right mix of investments, i.e. stocks, bond, real estate, and other alternatives that aligns with your goals, objectives and risk tolerance.
Using this approach, your returns from year to year may not match the top performing portfolio, but neither are they likely to match the worst. More importantly, this is a ride you are more likely to stick with as yearly portfolio returns will be less volatile and more consistent.
Just as drivers of cars with no suspension change their route to avoid potholes, investors with concentrated portfolios may resort to market timing and constant trading as they try to anticipate the top-performing countries, asset classes and/or segments.
Here is an example to show how tough this is to do in the markets. Among developed markets, Denmark was number one in returns for 2015 with a return of more than 23%. Yet a big bet on that country the following year would have backfired as Denmark slid to the bottom with a loss of nearly 16%.
While it is true, the U.S. stock market has been a strong performer in recent years holding the number three positions among developed markets in 2011 and 2013, first in 2014, and sixth in 2016. However, a decade before, in 2004 and 2006, it was the second worst performing developed market in the world.
Predicting which part of the market will do best over a given period is also tough. For example, while there is ample evidence to support why we should expect positive premiums from small cap and value stocks over time, these premiums are not laid out evenly or predictably across the map, nor do they occur every year. U.S. small cap stocks were among the top performers in 2016 with a return of more than 21%. A year before, their results looked relatively disappointing with a loss of more than 4%. International small cap stocks had their turn in the sun in 2015, topping the performance tables with a return of just below 6%. But the year before that, they were the second worst with a loss of nearly 5%.
If you have ever taken a long road trip, you will know that conditions along the way can change quickly and unpredictably, which is why you need a vehicle that is ready for the worst roads as well as the best. While diversification can never completely eliminate the impact of bumps along your particular investment road, it does help reduce the potential outsized impact that any individual investment can have on your financial journey.
With sufficient diversification, the jarring effects of performance extremes level out. That in turn, helps you stay in your chosen lane and on the road to your financial destination.
Happy motoring and happy investing.