Diversification Key to Disciplined Investing
Remember the story of Chicken Little? (Or Chicken Licken or Henny Penny, depending on where you live.) An acorn drops on his head, leading Chicken Little to believe the sky is falling. He proceeds to whip everyone around him into a frenzy, and they march off to tell the king about the falling sky. The story’s ending varies; in the U.S. version, all of the travelers live to tell the tale and learn from their experiences.
How did one little acorn set off this whirlwind of paranoia and alarm? In short, Chicken Little & Co. let their emotions – primarily fear – get the best of them. Instead of examining the evidence to make rational, informed decisions, they responded to the falling acorn with a knee-jerk reaction stemming from the self-preservation instinct.
As investors, we can learn much from Chicken Little. Our money is closely tied to our emotions. Fear, especially, surrounds our decisions about money and planning for the future. In 2019, 49% of Americans said their top retirement-related worry is running out of money.1
It’s no wonder, then, that so many investors veer from the course when market volatility increases. When markets drop, we naturally feel worried and scared – and we make snap decisions that take us away from the game plan.
What can advisors do to help clients separate emotions from their portfolios? In short: Diversify. Diversification helps smooth out the rough edges of volatility, which can help reduce the “knee-jerk approach” in investing.
Many Eggs, Many Baskets
A diversified portfolio reduces concentration risk, which occurs when investors are exposed to only a single asset class or asset region. Diversification concentration risk, which occurs when when investors are exposed to only a single asset class or asset region. Diversification helps reduce that risk by investing in a variety of asset classes, industries and geographies.
All assets have periods when they overperform and underperform, and it’s impossible to predict when they’ll go either way. The key is to find a mix of assets with low or negative correlations. In other words: Look for assets that haven’t historically moved in the same direction at the same time.
The goal of a diversified portfolio is to provide a buffer against volatility, ideally resulting in a balanced return that is likely to be less than the best performing asset class but better than the worst. Will diversification lead to giant short-term gains? Probably not. But in investing, it’s the long-term game that matters, and diversifying may lead to more cumulative returns over a longer period of time.
Finding the Right Mix
Where do you start with diversifying a client’s portfolio? First, look at investing in securities across companies or sectors. Consider different security types, including Exchange Traded Funds (ETFs), Real Estate Investment Trusts (REITs), and commodities. Don’t overlook international securities; concentration risk can also increase when portfolios focus too heavily on one global region.
If it fits the client’s profile, look at adding fixed income assets to the mix. Additionally, consider adding a blend of investment sub-types, such as a mix of small-cap and large-cap securities.
Diversification isn’t a set-it-and-forget-it approach. It’s vital to regularly review the portfolio to ensure that the investor is properly diversified to match their risk tolerance and goals. Even the most diversified portfolio can become unbalanced due to market activity and changes in the client’s life.
Diversification is a key part of disciplined, focused investing. While you may never completely ease your clients’ fears for the future, you can help reduce their likelihood to make emotion-based decisions by educating them on the benefits of diversifying. Hopefully, the next time the market drops, they’ll see it as an acorn and not a sign that the sky is falling.
1 Harriet Edleson. AARP. May 21, 2019. “Almost Half of Americans Fear Running Out of Money in Retirement.” https://www.aarp.org/retirement/planning-for-retirement/info-2019/retirees-fear-losing-money.html. Accessed Oct. 1, 2019.
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This content is provided for informational purposes only. This material does not constitute an offer to sell or a solicitation to buy any securities. All investments are subject to risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. The third-party information and opinions contained herein, have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by AE Wealth Management.