by James Parkyn
At its core, investing should be a relatively simple process. However, when emotions, misguided theories and bad advice enter the picture, things can get very complicated.
The right way to invest is to decide on an asset allocation strategy that fits your goals and risk tolerance while ensuring your portfolio is broadly diversified across asset classes and geographies. Then, you implement the strategy by selecting low cost securities and staying invested through the ups and downs in the markets to reap all the returns they are offering.
Of course, it takes expertise to optimally follow this recipe, including choosing the best securities to do the job; rebalancing periodically back to your target asset allocation; and making sure your portfolio is tax efficient.
Nevertheless, the guiding principle should be simplicity. But many investors opt for just the opposite—they choose to make their portfolios more complex.
That’s not surprising. They are bombarded every day with news about the economy, international affairs and market ups and downs. They hear pitches from advisors about the latest specialized investment opportunity, and they end up buying.
Their portfolios become packed with a wide variety of investments—evidence of the different fads and theories they’ve fallen prey to over time. They may even believe they have diversified their portfolio by adding narrowly focused funds or individual stocks. In fact, the result is not diversification but di-worse-ification—they’ve made their portfolio worse by not optimizing their diversification.
If they were to take off the fund wrapper and look at the underlying securities they own, they would find they had increased their risk by weighting it toward a particular sector, region or asset class, and incurred high management fees to do so. All will be well when the market is going up, but when the wind turns their returns can end up on the rocks.
For example, there’s a huge number of mutual funds and ETFs focused on the tech sector. They’re popular these days with people hoping to cash in on this year’s tech sector rally. In my previous blog, I discussed the dangers of becoming transfixed by the U.S. stock market, as its led higher by tech stocks, to the detriment of other asset classes, such as emerging markets.
Another example is the current search for yield in light of historically low interest rates. This is leading some to take on more risk by concentrating their portfolio in dividend stocks or other higher yielding securities.
There are many other possible sector or tactical bets you can make, but they all share the same defect—you are trying to outsmart the market by forecasting winners and losers. We know from long experience that this doesn’t work over the long run and that all these bets are not helping to diversify your portfolio.
On the other hand, robust, global diversification does work. By combining securities whose performance is not well correlated, you lower your risk without reducing your expected returns.
It’s not easy to stay disciplined when the economy is going through a sustained period of turbulence and the markets are volatile. But it’s good to know that sticking to simplicity in your investments is your best choice when everything else has become so complicated.