Diversification is not enough to save your investment portfolio

Putting all your money on a “sure thing” is a bad idea. That’s why investors diversify to mitigate risk. What is lost, however, is that diversification alone is often not enough to save you during a major market downturn.

Anyone can buy a wide basket of stocks and bonds representing a wide range of sectors and countries. In fact, many people do just that and then ‘set and forget’ (also known as the buy and hold approach), believing it’s the best way to navigate the inevitable ups and downs. of the market. While this sounds good in theory, the results are often disappointing in practice.

Managing risks: the Pareto principle

The Pareto Principle, also known as the 80/20 rule, is named after Vilfredo Pareto, a 19th century engineer, economist and philosopher. The story goes that while working in his garden, Pareto noticed that 20% of the pea plants produced 80% of the peas.

Since then, his theory has been applied in many fields. Businesses, for example, often find that 80% of their profits come from 20% of their customers or that 80% of their productivity comes from just 20% of their employees. I have found that this principle also applies to investment markets.

Whether you look back five years, three decades, or the turn of the 20th century, stocks only spend about 20% of the time reaching new highs. In accordance with the Pareto principle, this is also when around 80% of the gains occur.

This is part of the reason why “settle it and forget it” is flawed. An alternative approach is to combine diversification with a two-pronged strategy: the use of low-cost investment vehicles during periods of market growth combined with highly targeted and well-documented risk management techniques to reduce (or eliminate) losses during those extended periods when markets are either declining or recovering from declines.

Profitable level

Another inherent flaw in the buy and hold investing approach is that few people actually buy into it, in my experience. This is because most investors don’t have the stomach for volatility, so they sell at the first sign of a downturn.

This translates into losses (and missed opportunities), which are only confused when you consider what it takes to recoup them. For example, when an investment portfolio loses 10% one year, it needs an 11% gain the following year to break even. This difference is amplified when the losses are greater.

Without the training to select low-cost funds and the discipline to exit them based on objective evidence, most investors would likely not experience an 11% gain after a 10% decline the previous year – even if the broad market was increasing dramatically. It would probably take them a lot longer. The reason is simple: an emotional investor is a mediocre investor, which in cases like this means that he is likely to make decisions that will extend his “payback interval” which stifles the value of the portfolio. and endangers pensions.

Become international

Increasing international exposure might be a way to go beyond the typical set-up and forgetfulness approach. There is no doubt that from 1999 to 2018, domestic stocks, compared to the 20 other major markets in the world, performed the most consistently, according to my company’s research.

But during this same period, the United States was the best performing market only once (2013). In contrast, Brazil, Russia, China, Indonesia, Turkey and Japan – all of which have been much more volatile during this time frame – have each taken the top spot on multiple occasions. This reality benefits investors with a more nuanced plan of attack.

A big caveat about this is the market overlap. Gerber, a Michigan-based baby products brand, is now owned by Swiss giant Nestlé. Sprint is a subsidiary of SoftBank, a Japanese holding company. And perhaps the best-known example is Budweiser, which is owned by Brazilian-Belgian multinational company Anheuser-Busch InBev. Investing in these type of companies may make sense, but they will only add to your exposure to the United States instead of offering market diversification.

Put together

So, to sum it up, here is an alternative approach that buy and hold investors might consider taking instead. Invest in specific holdings with low cost funds that help diversify industries and markets. At the same time, adhere to evidence-based risk management: historical research, probability analysis, and predetermined exit points.

The details of your investment strategy should depend on your risk tolerance and time horizon, as well as your understanding of how market forces tend to play across different industries and countries. Learn how to do it right or find a professional who can, and you may be able to minimize your losses during market declines and maximize your gains at new highs.

The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.

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