19330 Jesse Lane,
May 19, 2020
Loza, Beck & AssociatesSteven Beck, AWMA©, AIF©
Why is diversification so important? The straightforward answer is to reduce portfolio volatility in an effort to produce a more consistent rate of return. But, if you have a long time horizon, wouldn’t it make sense to weather the volatility in anticipation of higher overall returns? Sometimes, and in fact quite often, this is not the best course of action. Why is that? To take a somewhat extreme example, consider an investment that suffers a 50% loss. It now has to double (100% return) in value just to get back to its initial investment. To keep it simple, let's assume that the decrease and increase of the investment took one year each. If you take an arithmetic average over the two years, you would get 25%(-50+100 / 2 = 25). But you most certainly did not average 25% over the past two years. Taking this extreme example and using it in a more practical manner illustrates the importance of keeping portfolio volatility to a minimum.
Consider two different portfolios: one portfolio that returns a consistent 6% annual rate of return and another that fluctuates wildly from year to year, but has an arithmetic average of 8% annually. Which would be the better investment?
As you can see from the graph above and the chart below, the portfolio with a consistent 6% rate of return handily beat a portfolio that averaged an 8% return with increased volatility over a 20 year period.
This same principle applies to all volatile portfolios, even ones that never have a negative annual return. Consider the chart and accompanying graph below. The same 6% RoR portfolio is compared to one whose annual returns alternate between 14%, 6%, and 0%. Even though its arithmetic annual average is higher at 7%, the 6% fixed portfolio still does slightly better over a 20 year period.
The bottom line: volatility is usually something that should be avoided if possible when investing. It can cause short term liquidity issues (being forced to sell an investment when it is performing poorly), and can be a drag on portfolio performance with longer term investments, illustrated above.
As everyone has seen over the past several months, the current pandemic and the resulting stay-at-home orders for a large portion of the country sent domestic and global financial markets into a tailspin. To amplify the crisis, a short-lived price war between Saudi Arabia and Russia sent oil futures contracts into negative territory for the first time ever; most major domestic market indices were down over 30% YTD by late March. The March lows were followed by one of the best Aprils in history, with most major domestic indices up nearly 30% from their March 23rd lows. However, the 30% loss followed by what could seem like an offsetting 30% gain has still left the major indices in double-digit losses for the year (excluding the NASDAQ, which has done well in the recent recovery due to its tech-heavy weighting). In order for an investment to recover from a 30% loss, it would need to gain 42%. These wild market moves over the past several months have only highlighted the importance of maintaining a well-diversified portfolio.
How are your investments positioned? Did the past few months highlight risks that you didn’t know you were accepting? Designing your portfolio with the goal of reaching its maximum risk-adjusted rate of return with minimal volatility is essential to your potential for long-term financial success. This is where we can help. While there are several key elements that contribute to the success of an investment philosophy and every person’s situation is different, we believe proper diversification is essential to providing the best risk-adjusted long term rates of return.
If you have specific questions about your own investments and how to better diversify your holdings, or just need some help and direction financially, please feel free to ask below and we will reach out to you soon.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. The information presented does not constitute a solicitation for the purchase or sale of any security and is not a recommendation of any kind. Please consult your LPL financial advisor before making financial decisions. When discussing the domestic market, we considered the S&P 500, Dow Jones Industrial Average and NASDAQ. Indexes discussed are unmanaged and you cannot directly invest into an index. Past performance is not a guarantee of future results. Diversification is an investment strategy that can help manage risk within your portfolio but it does not guarantee profits or protect against loss in declining markets. All investing involves risk, including the potential loss of principal. The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. These examples do not represent any specific product, nor do they reflect sales charges or other expenses that may be required for some investments. The investment return and principal value of the security will fluctuate so that when redeemed, may be worth more or less than the original investment. (05/20)