The stock market hasn't been a happy place so far in 2016. But for long-term investors, the real risk right now is losing sight of the big picture and making counter-productive short-term decisions.
So we'd like to provide some perspective on why a properly designed, long-term portfolio is still a good place to be. First, it's worth pointing out that the market correction that we've seen in the past couple of months isn't unusual. In fact, it's pretty routine: Historically, market declines of at least 10% have occurred once a year.
Temporary declines are the market's self-correcting mechanism, its way of "repricing" stocks, bonds and other investments that have become expensive relative to their fundamentals.
It's important to remember that, while we're experiencing some turbulence, we still have a long "flight" ahead of us to your financial destination. Thus, it's important to keep your cool. And that means maintaining a diversified portfolio that is tailored to your time horizon, goals and risk tolerance. Staying diversified and re-balancing are both crucial and we are always on the lookout for opportunities in this regard.
Diversification is vital because of its ability to enhance returns while mitigating volatility. Way back in 1952, Nobel Prize winner Harry Markowitz memorably deemed diversification the "only free lunch" in investing.
Let's look at a really simple example of how diversification helps investors. Say you owned a portfolio of technology stocks early in 2000. You may remember that this asset class had risen for the prior three years, and to many, it seemed poised to continue.
Alas, the law of gravity hadn't been repealed, and what had gone way up did indeed come down. And that tech-only portfolio got squashed. Diversification would have lessened the portfolio's total decline. By declining less when the markets are down, it allows us to compound our earnings faster once markets return to growth mode.
A basic diversified portfolio will typically include stocks, bonds and cash, including various types of each. History shows that different asset types perform differently under the same set of market conditions. Some are likely to rise while others fall. Stocks and bonds, for instance, have historically moved in opposite directions.
Does diversification prevent your overall portfolio from declining in a given time period? Absolutely not. What it should do is to make those declines a little less damaging to your portfolio. For a recent example, look to last year's fourth quarter. Commodity stocks fell 10.5%. But developed-market international stocks provided somewhat of a cushion: They rose 4.7%.
Diversification has been shown to deliver superior long-term results—but only when investors allow it to work over longer periods of time. Translation: Those who keep their cool in turbulent markets tend to come out ahead.
It's worth remembering that diversification has paid off during much nastier markets than this one. The period from 2000 through 2009, for instance, saw two brutal market crashes. Supposed you had $100,000 in a less-diverse portfolio—the Vanguard 500 mutual fund, which holds only large-cap U.S. stocks. Then, suppose you had another, more-diversified portfolio: $100,000 divided evenly between Vanguard's Small-Cap, Mid-Cap and Total International Stock index funds.
Run the numbers and you'll find that over that rocky 10-year timeframe, the less-diversified portfolio fell to $90,145. The more-diversified one, on the other hand, grew to $131,552—a difference of more than $40,000.
The power of diversification is one of the key reasons why investors shouldn't get swept up in the emotion of temporary market declines. At Align Wealth Management, our clients' portfolios are always diversified in accordance with their unique goals, timeframe and comfort level with risk. Don't hesitate to contact us if you'd like to learn more about how we seek to protect and grow your capital.