In the previous parts of our Investing Fundamentals series, we’ve asked how much risk investors should take, and looked into the predictability (and otherwise) of stock price movements. In this third part, we look at how diversification can prepare investors for whatever the markets may have in store.
Ever been on holiday where the weather wrong-footed you? The brochures promised tropical bliss, so you packed accordingly. Instead, you are greeted by bone-chilling wind and rain. Shivering and exposed, you resemble an undiversified investor.
As with the weather, financial markets can be unpredictable. Yet, in their own glossy brochures, investment providers often promise the equivalent of endless sun. Excited, investors pile in like bucket shop holidaymakers. This rarely ends well.
The only free lunch in investing
But there’s an answer to this cycle of unrealistic hope and illusion-shattering reality. It’s called diversification. Described by Nobel laureate Harry Markowitz as the only free lunch in investing, diversification is the equivalent of an all-weather wardrobe.
Smart holiday-makers, knowing that resort weather is never as consistently glorious as the marketing suggests, will pack for a range of climes. Alongside the shorts, sunscreen and T-shirts will be warm sweaters, umbrellas, and novels for rainy days.
Likewise, diversified investors will not hang their hopes on one asset class, or one sector, or one country, or one stock. They’ll spread their exposure across and within stocks and bonds, across different markets, industries and currencies.
Give yourself a smoother ride
Diversification increases the reliability and predictability of returns. Looked at another way, it smooths the way and reduces the sudden bumps in the investing road. The ups may be less spectacular, but the downs will also be less stomach-churning.
Like well-prepared travellers, diversified investors are ready for a range of outcomes. If the stock market is roaring ahead, they can have sufficient exposure to enjoy the benefits of that growth. But when stocks are down, they can also be protected under the relative shelter of government bonds.
Diversification works because different parts of financial markets aren’t perfectly correlated. As one asset class goes down, another may go up. Stocks, a growth asset, and bonds, a defensive one, are the classic example.
But diversification also applies within asset classes. In your stock portfolio, you can spread your risk across sectors. Instead of putting everything in technology or materials or financials, you can have a bit of everything. And instead of sticking to one country, you can diversify internationally, across developed and emerging markets.
Bonds and cash
You can diversify within a bond portfolio as well, spreading your holdings between government and corporate bonds, between long-term bonds and short-term bonds and between bonds of higher credit and lower credit.
And if you really must cut the holiday short because of an emergency at home or some other unpredicted event, you can have a portion of your investments in cash.
Ultimately, diversification works because you are giving yourself more choices. You are less reliant on any one variable. In this way, you are reducing idiosyncratic risk relating to single industries or stocks or countries.
Think of what happened during the tech boom of early this century. Piling into technology stocks worked very well, until it didn’t. At that point, many investors were left like a sun-seeker in an Ibiza cold snap with a suitcase full of swimsuits and sandals.
Greater peace of mind
There is still residual risk related to the market itself, of course. This so-called systematic risk is something you can’t diversify away. But the main point is you should do everything you can to increase the reliability of outcomes and eliminate risks you simply don’t need to take.
The outcome is greater peace of mind and an understanding that when markets get unsettled, as they inevitably do from time to time, you’ve packed your portfolio for a range of eventualities.
Call it all-weather investing.
Missed the previous articles in the series? Catch up here:
How much risk should you take?
Stock price movements: how predictable are they?
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