Stress Relief: Why You Should Diversify Your Portfolio
By William Landis
Investing can be an emotional rollercoaster. On any given day, the value of your portfolio can soar. When it does, you’re ecstatic, elated, and optimistic about your investing future. On any other given day, however, the opposite can be true.
When your investments lose money that elation turns to nervousness and that optimism turns to fear. Moving from up to down in a matter of days – or even hours – leaves you with questions about what went wrong. The unpredictable nature of markets is one of the most common problems faced by investors with poorly built portfolios. Investment risk can haunt you when you know the next market crash could be just around the corner.
The potential for loss is unnecessarily high when investors ignore this while building their portfolios. The straightforward solution that seeks to solve these problems is portfolio diversification.
What is portfolio diversification?
Portfolio diversification is a risk management technique that mixes a variety of investments and asset classes in a portfolio. The theory behind this practice is that investments perform well at different times, so combining them can reduce the risk of losing money for a given level of return. When combined, positive performance from some investments can neutralize negative performance from others – in simple terms you avoid making one concentrated bet. As a result, using diversification as part of your approach can lead to a safer, more satisfying investment experience.
Why is diversification important?
The following example illustrates why a diversified portfolio can be crucial. Let’s say your portfolio holds a single investment in shares of the Ford Motor Company. If vehicle sales drop and the Ford stock price plummets, you could lose a significant amount of your money. Diversification can help either reduce the loss, or even allow you to profit in this type of scenario.
As another example, let’s say in addition to Ford you invest in a few technology stocks, some entertainment stocks, treasury bonds, and maybe even gold. With this new diversified approach a drop in vehicle sales affects only one part of your portfolio directly. Having other investments tied to factors different from auto sales helps prevent you from relying too heavily on any company or industry.
People also often invest based on predictions or a “hot tip” on a stock, like Ford, in their portfolio. For every winner there’s a loser, and in reality there is no way to predict the exact price of any given stock. A recent example of false confidence came from Britain’s vote to leave the EU, or Brexit, as having a diversified portfolio was essential. If you had all of your money invested in a British bank, like HSBC, this event’s impact would have been drastically negative. If instead, you prepared by diversifying across asset classes, countries and industries, your portfolio would have been far less impacted. In the blog post, “Brexit Stress & the Benefits of Portfolio Balance,” diversification’s advantage through this is covered in detail.
The Future of Investing
Investors seek to increase the value of their portfolio over time while taking a comfortable and appropriate amount of risk. Trying to predict the market, economy, and specific company events can make this a difficult proposition. Diversifying your portfolio, however, is a smart and less risky option than betting on a single stock or company. And as the world changes with events becoming less predictable, diversification can be even more powerful. Because no one can predict the future and how it will affect financial markets, why not diversify your portfolio today?
Longwave Advisor takes an advanced approach to diversification. We design portfolios hedged to unpredictable economic outcomes by balancing investments that perform well in rising or falling economic conditions. The result is a portfolio that, by design, seeks to perform in any economic environment and more importantly at times creates the potential for downside protection. It’s important to note that diversification will not guarantee full participation in the upside of one asset, but over time it will lessen the downside risk while making the upside more consistent that should ultimately improve your portfolio. As they say in baseball, ten base hits will always outscore a homerun.
The figure above illustrates our portfolio risk allocation, balanced equally across diversified baskets of assets tied to different economic conditions. This approach is based on the fundamental drivers of assets and is what we call Next Generation Investing.
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