Turn on the business news or read a Wall Street research report and you’ll notice something: many people in the investment world will tell you where to put your money for maximum gain. Buy gold before it soars. Sell bonds before they crash. Or maybe speculate on this stock because it’s destined to go up. Like good comedy, the suggestion is that timing is everything. Do it right and you’ll be rich.
These dramatic predictions understandably generate headlines. But for the vast majority of investors, they really should be treated as no more than entertainment. Rather than attempting to time the market, a far better approach is to maintain a well-diversified portfolio.
So, why diversification instead of market timing? Let us count the ways:
- A properly diversified portfolio takes into account your specific needs. It’s based on factors such as your age, your risk tolerance, your time horizon and how much income you require in any given year. The aim is balance the amount of risk you’re comfortable taking with the (realistic!) long-term returns you seek.
- It’s an approach where all the parts support the whole. Contrary to what some may believe, diversification does not entail putting together a random collection of investments. Actually, it’s quite the opposite. Every asset class you own should work to support your overall objectives. For example, the job of your equity allocation is to deliver long-term capital growth, while bonds provide a steady stream of income.
- Diversification reduces portfolio volatility: Imagine there are two investors. One is ultra-aggressive, the other more conservative. The aggressive investor may only hold a few stocks at any one time. The conservative investor owns a basket of many stocks, and also has exposure to fixed income and cash. Say the aggressive investor loses 50% in one year, but the conservative investor only loses 7%. To get back to “even”, the aggressive investor needs a return of 100% in year 2. The conservative one? 7.6%. The lesson here is that seeking big returns by being too concentrated can devastate a portfolio. On the flip side, diversification leads to greater consistency of returns, and this results in better performance over time.
- You will enjoy peace of mind. There’s something to be said for having a portfolio that allows you to sleep at night. A well-balanced, diversified basket of assets allows you to do just that. On the flip side, investors who have most of their eggs in only a couple baskets are destined to see the value of their holdings experience severe volatility. Overly concentrated portfolios aren’t just bad from an investment standpoint, they make people anxious and too focused on day-to-day market movements. The way to be calm when markets are not? Stay diversified.
The Hare Gets the Headlines, the Tortoise Wins the Race
You’re probably familiar with the age-old tale of the tortoise and the hare: the two are racing each other, and at first, the speedy hare takes a large lead. Over time, however, the slow and steady tortoise gains on the ever-tiring hare and ultimately wins the contest. Think of the hare as an aggressive market-timer, and the tortoise as the well-diversified investor. Sure, the hare gets the headlines, at least in the beginning. But over time, it’s the consistent tortoise that wins the race.