Being a diversified investor is hard work

Written by multiforte on . Posted in News

If you’re like most investors, at any given time you will be looking at part of your portfolio and see that a once hot asset class has cooled. It’s no longer performing like it used to.

There is a strong desire to kick this losing asset class aside, and search out the next potential winner.

Right now, chances are, the loser in your portfolio is the bond investments.

And, you’re probably seeing headlines criticising bonds as weak performers and telling you that you would be wise to move on to other asset sectors. It’s easy to see why when you consider their recent relative performance.

Asset class performance is unpredictable

When it comes to investment asset classes, there is no discernible pattern in their performance from year to year that could help to predict the winners and losers. Providing a good reminder as to why diversification matters.

By blending different, complementary investments, we’re spreading our risk and creating opportunities for different parts of our portfolios to zig when others zag. A diversified portfolio means that some investments will do well while a few are doing poorly and others are doing average.

That’s perhaps the biggest frustration with diversification: comparison. It can be difficult to watch portions of our portfolios climb sky-high while others seem to be lost in the wilderness. It’s easy to focus on the asset classes that are doing well and compare them with the ones that aren’t doing equally well.

But that’s what makes diversification so useful. We have no way of predicting the winners and the losers. Diversification helps us cover a range of possibilities.

It also helps smooth the ride. Diversification doesn’t eliminate all risks, but it’s one fantastic shock absorber.

Being a diversified investor is hard work

Being a successful investor is not easy. It requires you to remain focused on the long term – even when your immediate response to weak performance from a given asset class is to change your allocation.

Here are five things to remember when you have the urge to tweak:

  1. With a diversified portfolio, your investment performance will always be worse than the best performing asset class – and you will always compare your performance to the best asset class, because this is what your brain is wired to do. For this reason your portfolio’s performance will always seem mediocre.
  2. The returns on your overall equity holdings will always be worse than the current hot stock pick.  Maybe it’s Dexcom or TPG Telecom. Or rewind 15 years and it’s Amazon and Cisco. Doesn’t matter. You’ll wish you had some of that, and ignore the fact that you also avoided owning things like FitBit which IPO’d in 2015 and then lost two-thirds of its value.
  3. You will never feel like you have enough of the good stuff in your portfolio. Emerging markets are the favourite? Australian equities are doing well? Why didn’t you own more of that?
  4. You will always hate something in your portfolio.  Really hate it.  Emerging markets have been a drag on a diversified portfolio for years and few investors were happy that they owned them in recent years. Right now, many hate bonds.
  5. That part of your portfolio that you love will turn on you in a flash.  You’ll hate it, and you won’t ever remember loving it. As we’ve seen, REITs led the charge in the past five years. Now, the tables have turned and recent returns have been lacklustre. Bonds have provided upside surprise for many years – often outperforming equities – and yet our love affair with this defensive asset appears to be over. We’re rather fickle, aren’t we? We want good performance and don’t want to be around for the bad times – even though we know we can’t predict or control what happens in the markets.

So, while you will often want to tinker, don’t. The single worst thing you can do in an environment like this is to start making changes to your investment policy.

An investment policy by design is not built around market performance – its purpose is to provide clarity on who and what you are investing for.

If you have thoughtfully constructed a diversified portfolio of investments that aligns with your policy goals, then stick with it.

The great thing about having a diversified portfolio is that it works both ways. While you may have a hard time dealing with the parts of your portfolio you hate, that’s the price of admission to take part in the asset classes or strategies that do perform well.

We believe it’s the best form of long-term risk management an investor can implement.

Conclusion

William Bernstein, in his book “Rational Expectations: Asset Allocation for Investing Adults” sums it up nicely:

“First and foremost, don’t even think about trying to extrapolate macroeconomic, demographic, and political events into an investment strategy. Say to yourself every day, ‘I cannot predict the future, therefore I diversify’.”

Sources: Carlson: A Wealth of Common Sense: “You Should Hate Some of Your Investments” (2013), “Diversification is no fun” (2016), “Updating my favourite performance chart for 2016” (2017); Osborne: Basson Asset Management “Diversification sucks” (2014).