…Investors are paying more and more attention to how certain strategies, asset classes or investments perform over shorter and shorter time frames…constantly looking for the best or worst performing sector/smart beta style/ETF/hedge fund/portfolio strategy during the latest two day or even two month sell-off or rebound. That’s not how you build a long-lasting portfolio. [This article discusses] some of the misconceptions about diversification.
The comments above and below are excerpts from an article by Ben Carlson (awealthofcommonsense.com) which has been edited ([ ]) and abridged (…) to provide a faster and easier read.
Since no one really knows how correlations will change and adapt in the future, it makes sense to build a portfolio with several different investment styles and strategies but this idea can be taken too far when you try to account for every single potential risk that exists.
Yes, it’s a good idea to understand how the various pieces of your portfolio generally act when there is turbulence in the markets, but it becomes a problem when you’re constantly window-shopping to try to find the best hedges or diversifiers. Negatively correlated assets sound great in theory, but they also increase the odds of lowering your overall returns. You can’t eat risk-adjusted returns after all. Each individual fund or security you hold is much less important than how all of your investments function together to reduce the overall risk in your portfolio.
Short-term performance numbers tend to miss the main tenets of true diversification.
Diversification is not about:
- Protecting you from terrible days, months or even years in the markets.
- Hedging every single risk or hiccup in the markets.
- Avoiding market volatility.
- Sidestepping every market drawdown.
- Finding strategies that will make you feel like a genius when the broader markets sell-off.
True diversification is about:
- Protecting you from terrible results over long time horizons (the only ones that should matter).
- Spreading your risks.
- Ensuring you can survive severe market disruptions and still be able to achieve your longer-term goals.
- Planning for a wide range of outcomes.
- Managing your investments without knowing how the future will play out.
- Reducing the probability of a large loss, but not completely eliminating risk altogether.
- Not going broke.
- Giving up on home runs to avoid striking out.
There’s no perfect way to completely hedge the downside of the markets while also enjoying all of the upside. Yet that’s what many investors are looking for when building their portfolios or hiring an investment manager.
Diversification isn’t about fully insulating your portfolio in the short term. Diversification can help at times in the short-term, but it’s really a long-term strategy.
They say perfect is the enemy of good. Investors miss out on good results by trying to be perfect. Trying to construct the perfect portfolio for every single market environment is a great way to own a bunch of competing holdings that don’t really get you anywhere. Plus, the ideal portfolio mix and strategy are only going to be known in hindsight.
The hardest part about long-term investing is dealing with the short-term movements in the markets. Diversification can help, but it’s not the be-all, end-all, nor should it be. Investors can’t expect to earn money in the markets if they’re unwilling to accept periodic fluctuations in their holdings.
Diversification works but it’s a strategy best suited for the long-term investor.