Ever ridden in a car with worn-out shock absorbers? Every bump is jarring, every corner stomach-churning, and every red light an excuse to assume the brace position. Owning an undiversified portfolio can trigger similar reactions.
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’s a real chance you may not reach your destination.
In the world of investing, a similarly bumpy and unpredictable ride can await those with concentrated and undiversified portfolios or those who constantly tinker with their allocation.
Of course, everyone feels in control when the surface is straight and smooth, but it’s harder to stay on the road during sudden turns and ups and downs in the market. For that reason, the smart thing to do is to diversify, spreading your portfolio across different securities and countries. That also means identifying the right mix of investments (e.g., stocks, bonds, real estate) that aligns with your 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 likelier to stick with.
Geopolitical events have often “shocked” markets around the world. It seems that lately, however, investors have developed a complacency toward these types of events. The investing road seems smooth, ignoring recent events like the US military strike in Syria and the Paris terrorist attack.
Recent research by Sam Stovall, chief investment strategist at CFRA Research and reported by the Wall Street Journal’s Steven Russolillo claims that much of the complacency is tied to the current stage of the market cycle (we are currently in the ninth year of a bull market). Stovall found that in bull markets since World War II, there have been 13 of the so-called market shocks and they prompted a 5% drop on average in the S&P 500. But during bear markets the S&P 500 has dropped 17% on average from exogenous shocks. He also found that the drops from the market shocks lasted longer in bear markets (two months or so) than bull markets (about 9 days on average).
Diversification can never eliminate the impact of bumps along your particular investment road, but it can help reduce the potential outsized impact that any individual investment can have on your journey. It can also help you avoid the feeling to do the wrong thing when “shocks” do some temporary damage to part of your portfolio.
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 investment destination.