Welcome to the next installment in our series of Oasis Wealth Planning’s Evidence-Based Investment Insights: Get Along, Little Market.
In our last piece, “Managing the Market’s Risky Business,” we described how diversification plays a key role in minimizing unnecessary risks and helping you better manage those that remain. Today, we’ll cover an additional benefit to be gained from a well-diversified stable of investments: creating a smoother ride toward your goals.
Diversification for a Smoother Ride
Like a bucking bronco, near-term market returns are characterized more by periods of wild volatility than by a steady-as-she-goes trot. Diversification helps you tame the beast, because, as any rider knows, it doesn’t matter how high you can jump, if you fall out of the saddle. High or low, you’re going to get left in the dust.
When you crunch the numbers, diversification is shown to help minimize the leaps and dives you must endure along the way to your expected returns. Imagine a graph of prices for several rough-and-tumble stocks. They seem to be moving upward over time but each stock offers a very bumpy ride. Bundled together, the upward trend by and large remains, but the jaggedness along the way can be dampened (although never completely eliminated).
If you’d like to see data-driven illustrations of how this works, check out “How to diversify your investments,” by financial author Larry Swedroe, or “When boring is good investing,” by financial author Craig L. Israelsen.
Covering the Market
A key reason diversification works is related to how different market components respond to price-changing events. When particular news causes one type of investment to zig, it causes another to zag. Instead of trying to move in and out of favored components, the goal is to remain diversified across a wide variety of them. This increases the odds that, when some of your holdings are underperforming, others will outperform or at least hold their own.
The results of diversification aren’t perfectly predictable. But placing a big blanket of diversification over the zigs and zags of individual stocks can reduce the pain you feel when a one of them drops unexpectedly. (And almost all drops are unexpected, otherwise you would have avoided it.) That big diversification blanker can capture market returns where and when they occur and it replaces guesswork with a coherent, cost-effective strategy for managing desired outcomes.
Speaking of blankets, a classic illustration of diversification is called the Crazy Quilt Chart. After viewing a color-coded layout of which market factors have been the winners and losers in past years, it’s clear that the only discernible pattern is that there is none. If you can predict how each column of best and worst performers will stack up in years to come, your psychic powers are greater than ours.
Diversification offers you wide, more manageable exposure to the market’s long-term expected returns as well as a smoother expected ride along the way. Perhaps most important, it eliminates the need to try to forecast future market movements, which helps to reduce those nagging self-doubts that throw so many investors off-course.
So far in our series of Evidence-Based Investment Insights, we’ve introduced some of the challenges investors face in efficient markets and how to overcome many of them with a structured, well-diversified portfolio. Next up, we’ll pop open the hood and begin to take a closer look at some of the mechanics of solid portfolio construction.