As we discussed in our previous blog, “Managing the Market’s Risky Business,” properly diversifying your investment portfolio helps to minimize unnecessary risks and better manage those that remain. But diversification provides us with an additional benefit: It helps to create a smoother ride toward our goals.
Like a bucking bronco, near-term market returns are characterized by periods of wild volatility. Diversification helps you “break” the horse. That’s important because, as any rider knows, if you fall out of the saddle, you’re going to get left in the dust.
When you crunch the numbers, we see that diversification helps to minimize volatility along the way to your expected returns. Imagine several jagged, upward trending lines on a chart; they represent several kinds of holdings. Individually, each holding has a bumpy ride. Bundled together, however, the upward trend remains, but the jaggedness along the way can be dampened (albeit never completely eliminated).
If you’d like to see a data-driven illustration of how this works, check out this post by CBS MoneyWatch columnist Larry Swedroe.
A key reason diversification works is related to how different market components respond to price-changing events. When one type of investment zigs due to a particular news story, another may zag. Instead of trying to move in and out of investments as they zig and zag, wise investors remain broadly diversified. This increases the odds that, when some of your holdings underperform, others will outperform, or at least hold their own.
The results of diversification aren’t perfectly predictable. But it is a coherent, cost-effective strategy for capturing market returns where and when they occur, and it’s far better than guesswork.
The Crazy Quilt Chart is a classic illustration of this concept. It shows that there is no discernible pattern of how different asset classes have performed.
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.
Diversification provides not only more manageable exposure to the market’s long-term expected returns, but also a smoother expected ride along the way. Perhaps most important, it eliminates the need to try to forecast future market movements—and that helps to reduce those nagging self doubts that throw so many investors off course.
In our next blog, we will pop open the hood and begin to take a closer look at some of the mechanics of solid portfolio construction.