Stordahl Capital Management’s Evidence-Based Investment Insights: Insight #6: Get Along, Little Market
Welcome to the next installment in our series of SCM’s Evidence-Based Investment Insights: Get Along, Little Market
Our last piece, “Managing the Market’s Risky Business,” described how diversification plays a key role in minimizing unnecessary risks and helping you better manage those that remain. To round out the conversation, we’ll cover another benefit to be gained from a well-diversified stable of investments: It helps create a smoother ride toward your goals.
Diversifying 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 that beast. Because, as any rider knows, it doesn’t matter how high you can jump if you fall out of the saddle.
When we crunch the evidence-based numbers, we discover that diversification helps minimize the bucking you must endure along the way to long-term expected returns. Imagine several rough-and-tumble, upwardly mobile lines that represent several kinds of holdings. Individually, each represents a wild ride. Bundled together, the upward mobility remains, but the jaggedness along the way can be smoothed (albeit never completely eliminated).
Fidelity’s “guide to diversification” describes how diversification and individualized portfolio construction can help you tame the market’s best and worst investment outcomes according to your goals. For a more detailed, data-driven illustration of the same, check out “How to diversify your investments,” by financial author Larry Swedroe.
Covering the Market
A key reason diversification works is related to how different market components respond to price-changing events. When one type of investment may zig due to particular news, another may zag. Instead of trying to move in and out of favored components, the goal is to remain diversified across a 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 result of diversification isn’t perfectly predictable. But it offers a blanket of coverage for capturing random market returns where and when they occur. This goes a long way toward replacing nerve-wracking guesswork with a more coherent investment strategy.
The classic Crazy Quilt Chart illustrates this concept. After viewing a color-coded layout of which market factors have been the annual winners and losers in past years, it’s clear there is no discernable pattern, just a crazy array. 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.
Your Take-Home
Diversification offers you broad, more manageable exposure to the market’s long-term expected returns and a smoother expected ride along the way. Perhaps most importantly, it eliminates the need to try to forecast future market movements, thus reducing those disruptive self-doubts that throw so many investors off course.
So far, we’ve introduced some of the challenges investors face in efficient markets and how to overcome them with a well-diversified portfolio. Next, we’ll pop open the hood and take a closer look at how to tune up your own investment portfolio’s performance.
If you want to discuss this concept further, we offer a complimentary 15-minute call to answer your questions and to share how we can help.
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