Diversification, in the words of my favorite financial advice guru, Nick Murray, is a deal made with heaven. You agree to never make a killing — to give up the opportunity for maximum upside returns — for the blessing of never getting killed. It’s the ultimate trade-off. And it has a cost. The cost is the “never make a killing” part.
This week, perhaps for the first time in almost four years, we can once again appreciate the benefit of not getting killed when markets decline viciously. But as time passes between periods of market calamity, it’s easy to forget again. We forget that markets can and do go down. We forget about the deal we made with heaven, and we start pining for a killing.
Just a month ago, I spoke with a prospective client who wondered why we weren’t simply piling into the S&P 500. I responded with my usual bit about disciplined diversification: U.S. markets have outperformed, but they don’t always, and we keep other types of equities in the portfolio because we cannot know the future.
His response: “Those other places are obviously broken. The U.S. is the best market out there — Bogle said so, and there is no way the Dow will go down 900 points from here.”
I don’t know where that particular figure came from, but it represents a less than 6% decline from where the Dow stood a month ago. I view a 10% decline as a run-of-the-mill event and expect it once a year. This investor thought a 6% contraction impossible, showing a complete lack of understanding of markets.
When people combine greed with a belief that markets simply can’t go down, they define “risk” as “not having money the top-performing investment right this moment.” The more people think this way, the closer we are to the end of the bull market.
The Cost of Diversification
In 2013 and 2014, the cost of diversification was very evident. Those of us who maintained diversified portfolios of equities — with some U.S. stocks, some emerging-markets stocks and some non-U.S. developed world stocks (e.g, Europe, Canada, Japan) — have painfully underperformed the U.S. equity markets.
To the extent that we have maintained our disciplined diversification across U.S. equity sectors (and not focused purely on the financials and consumer discretionary companies that have knocked the cover off the ball), we have further underperformed. And those who diversified out of equities — into bonds or commodities or almost anything labeled alternative —have underperformed even more.
But to complain about this underperformance is to secretly covet the concentrated portfolio. It’s to covet “making a killing” and to step, ever so innocently and lightly, away from your agreement with heaven.
The psychology at play here is simply greed. It is the wish that you had been otherwise invested in order to capture more upside — and it is as predictable among investors as it is pernicious. With this thinking, you have begun to move toward concentrating your portfolio at the worst possible time.
As more and more people concentrate more and more wealth in equities (pushing price-to-earnings ratios beyond reason), there are fewer and fewer people able to join later. When the last person sells his bond portfolio in favor of stocks, there is no more money to support the whole bloated, hype-ridden mess, and down it comes, sure as I am sitting here.
Either you believe that you can pick and choose the “right” investments that you will then “get into” at the right time and “get out of” at the right time, or you diversify and express yourself in markets through patience and discipline (employing consistent dollar-cost averaging and rebalancing, regardless of markets). Over short periods of time, performance will vary widely — and there is no way to know which investments will show better (or worse) performance in the very next period.
But, almost certainly, diversifying and staying patient and disciplined will leave you time to live a far better life, to make and save more money, to read good books, learn new skills or fly kites with your kids. And though I can’t predict the future, I believe that in the long run, diversification will pay off.
While no two types of diversification will act the same over a short period, research has shown that most portfolios with 60% equities (regardless of the equities chosen) will converge over long enough periods of time. Whatever else you include in your long-term portfolio (bonds, cash or alternatives) will provide stability in the difficult times but will reduce your long-term performance (another important trade-off to consider).
There is no way to predict or prove any of this going forward, since past performance is no guarantee of future results. It is almost entirely a “faith in the future” kind of thing. That said, it is a kind of faith worth cultivating. Diversification is a decision. It is an admission of humility as much as it is choosing your life over your portfolio.
Originally Published at NerdWallet.