5 Thoughts On Diversification

September 22, 2015

1. Treat Your Portfolio Like Your Body

The best example to equate to investing is personal health. Things that people do to affect their personal health throughout their life have a lasting effect on their ultimate health and quality of life.

Eating cheeseburgers every day for 20 years has an impact similar to not contributing to a 401(k). Selling out over fear at a market bottom is like shattering a leg sky-diving. These are things that can’t be fully recovered from.

Just like failure to take good care of their bodies, investors tend to abandon sound investment strategies for unsound ones and make poor investment decisions. For example, let’s do an exercise with Investment A and Investment B.

Following are the two assumed annual rates of return patterns over three years:

Investment A or Investment B?

Investment A: 5 percent, 5 percent, 5 percent

Investment B: 8 percent, 8 percent, 8 percent

Which one would the typical investor choose? Most investors would choose investment B. Any rational person, given only this information, would choose the higher rate of return.

What about over five years?

Investment A: 5 percent, 5 percent, 5 percent, 5 percent, 5 percent

Investment B: 8 percent, 8 percent, 8 percent, -10 percent, 8 percent

Adding years four and five helps to give more information.

If an investor would stay invested in option A, the total return would be about 28 percent. Option B would provide about 22 percent. If an investor switched from option A to option B after year three and stuck with option B for years four and five, the result would be about 13 percent after year five. Worse yet would be the investor who switched back to option A in year five, after trailing with option A in years one through three and losing money in option B for year four, which would yield about 9 percent.

Many investors are facing a similar decision now. Diversified portfolios have largely underperformed the S&P 500 the last few years. Simple logic would pull investors toward investing solely in the S&P 500. However, that logic leads to the worst result in the example above.

A year of gains, or even five years, can be wiped out in a matter of days. As such, many investors have been irreparably harmed by abandoning solid strategies to chase recent winners.

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