Diversification Means Never Being the Best
Most have learned about the benefits of having a diversified portfolio. We know intellectually that we should diversify our portfolios. But why does having a diversified portfolio mean we never get the highest possible return? There’s always an asset class, whether it’s gold, foreign stocks, the S&P 500, the NASDAQ, or something else that is outperforming our diversified portfolio. So why diversify? Isn’t diversification counterintuitive? Don’t we want the best possible return?
Does the best return equate to the best overall result? I don’t think so. I don’t know what the market will do tomorrow, next week, or over the next 3 years, yet there are many who claim they do. You can turn on the TV and see the so-called experts predicting and pontificating on what’s the best investment right now. Do you think it’s possible for them, or anyone else, to predict what the markets will do tomorrow?
The truth is, tomorrow thousands of unexpected things will happen around the world that will drive the markets.
If we truly have no way of predicting the market effectively, if past performance doesn’t dictate future performance, then when we choose what’s hot there are several problems including buying what is overpriced and in-favor, taking a gamble, holding our breath, and hoping to win. Is this how to build your financial future, by gambling and playing a game?
A study of 65,000 self-managed stock portfolios, found that active traders underperform 7% annually compared to buy-and-hold investors.* My goal isn’t to beat the market or to always be in the best asset class. My goal is to achieve closer to market returns over the long-term. By delivering closer to market returns in our portfolios I believe we could have the likelihood of being successful financially.
How do we do this? What’s our strategy? I believe in academic portfolios. I believe in modern portfolio theory. We do this by taking asset classes that have had predictable personalities in the past and meld them together based on your risk tolerance to build a portfolio that doesn’t tell us what the return will be, but let’s know that we’re going to get what the market does hopefully as predictably as it has done in the past. Will I know what this portfolio will do tomorrow, or in the next three months or 3 years? Absolutely not. However, if we own the market, are diversified, stay unemotional, and consistently rebalance, I believe we could do well.
So yes, we won’t get the best returns when we’re diversified, but what we will get is performance that’s closer to market returns over our lifetime. Next time you sit down to invest, decide if you want to gamble with your future or invest with a plan that can help you work towards success.
Being systematic, unemotional and diversified won’t guarantee that we get the best short-term return, but I believe it could lead to the best overall result.
* Barber, B.M. and T. Odean (2000), “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55:773- 806.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing involves risk including potential lack of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. No strategy ensures success or protects against a loss.
