Let me share some thoughts about what we call Home Sweet Home, or what behavioural economists call Home Bias. Or what investors need to remember—to achieve a diversified portfolio.
Have you heard of what investors in Sweden do ? Although all of Sweden’s stocks represent only about 1% of the world’s market value for equities, statistically the mean Swedish portfolio contains 48% of Swedish stocks. In this respect, it is clear that the IKEA-creators suffer from Home Bias.
The better choice would be to diversify geographically. Why?
Well, stock markets always rise.
Ok, not really, but on a day-by-day basis, stock markets rise 51% of the time. Yes, bad things do happen in stock markets and the events of 2008 (or any of the other crashes) come to mind, but we overdo it sometimes. No worries, though, because everything that lives and breathes require a break—once in a while. So let it rest and wait for it to get back in the game.
Looking at historical frequencies of market falls can help calm the mind and prepare your response, or better—“non-response”—to future market corrections.
Regrettably, the secret is that it’s impossible to accurately pick which stocks, sectors, or regions will lead, or lag at any given time. Of course, there would be momentum and you can get lucky and ride a high wave for a while. And with lots of time invested, you can even develop a system that has a high probability in identifying more winners than losers. But that approach takes time and effort as well as a steady hand (meaning: having the discipline to—emotionlessly—adhere to your system and not override it with “feelings”). Not as easy as it sounds, in view of our often “I-can’t-help-it-irrational-behaviours”.
For those who do not plan to invest a few hours a week (every week!), a balanced, globally diversified portfolio allows you to always participate in markets that are rising and gives you the opportunity to buy low, when other asset classes are correcting.
Unfortunately, too many people make the mistake of focusing only on their home markets. That’s understandable as it is their home ground and they are more familiar with their local stocks. Nevertheless, buying stocks headquartered near their houses, as if being within driving distance could somehow make companies safer, is too narrow-minded.
Some take the mistake even further and are over-weighted in large cap (= biggest companies on the stock exchange) only; thus missing the opportunities that mid and small caps offer.
But neglecting world asset classes will hurt. Remember the so-called “Lost Decade” between 2000 and 2009? From the perspective of an US-investor the S&P 500 suffered a total decline of 9.1% during that time.
However according to data from Dimensional Fund Advisors, U.S. small caps and REITs (Real Estate Investment Trusts) closed that decade with solid gains. International asset classes fared even better.
Chart source: Dimensional Fund Advisors
As I come from a trading background, I understand the idea that “winners” can be identified through market timing. And I do have a small portion of my assets in a Trading Account (to keep me busy).
But that has absolutely nothing to do with a person’s retirement income requirements.
These days, when I hear people boasting that such-and-such a trade had resulted in some eye-popping return, I think: “Wow, that’s great, Congratulations! Now, how much income do you need in your non-working years?”
Investors who can find calm and clarity amid chaos, amid inevitable changes in market conditions, or amid personal situations, understand that a diversified portfolio—and not a so-called “winning” trade—is the key to financial security.
Ask yourself: Would you rather win, or would you rather be financially secure? Because they are not the same thing.
Do bear in mind that a faster clock-speed (a measure of cycle-times on multiple levels; product, technology, process cycles) shortens the period of competitive advantages, resulting in a screaming need for greater diversification. Because if competitive advantages are coming and going faster than ever, investors need to cast a wider net, in order to ensure that their portfolios reflect the phenomenon.
When assessing the current diversification of your portfolio, do remember the portion that has been invested in your company’s stocks. Certain statistics have indicated that about 5 million Americans have more than 60% of their retirement savings in their companies’ stock. That can hardly be considered diversified!
As employees of Worldcom and Enron have discovered the hard way, workers risk losing both their jobs and the bulk of their retirement savings all at once— A Classic Double Whammy.
When you have more than 10% of your retirement money invested in the company you work for, diversify as quickly as possible. Now, why should you do that?
Well, have you asked yourself the question of how risky it is to hold the shares of a single stock, rather than a diversified portfolio?
The economist Lisa Meulbrock estimated (in 2002) that a dollar in a company stock is worth less than half the value of a dollar in a fund.
Still, when you select your ETFs, bear in mind that there is no evidence that a past performance predicts a future performance and do ignore the marketing gimmicks where Fund Houses pick out a fund (Survivorship Bias) that had beaten the benchmark index for a certain period and heavily advertise it. The probabilities are quite high that this fund will underperform the market in future.
Apart from stocks, every diversified portfolio should contain Bonds, Real Estate Investment Trusts (or Real Estate itself when the portfolio is large enough) and some commodities, like Gold and Silver. In other words, investments from different risk classes.
Along with the importance of diversity, the risk-versus-reward tradeoff is one of the classic rules of investing: If you want higher rewards, you have to take on greater risks. Assess your risk profile, and then invest accordingly. If you cannot bear the volatility, you probably would want to have your money in more conservative investments; nevertheless, do not leave more money other than your emergency funds in the Savings Account or in Fixed Deposits.
Source: BlackRock
And do not forget to revisit your choices periodically: Not daily, but yearly. Because your attitude towards risk depends on the frequency with which you monitor your portfolio.
Why do you check your stocks twice a day, but your cholesterol twice a decade? The former is killing your emotions and the latter is killing you.
Additionally, don’t let the media influence your decisions on your long-term investments because short-term thinking is the root of most of our problems. Short-termism is eating portfolio performance.
Lastly, you can control your investing decisions; your education; whom you choose to listen to; what you choose to read; what you choose to pay attention to, and how you choose to respond to certain events. But you cannot control what Central Banks do; the laws the government sets; the next job report, or whether a company will beat the earnings estimates. So focus on the former and try to ignore the latter.
That was a long post, but thank you for reading on.
What I wanted to say could be easily summarized in two lines:
You should totally do Diversification and Patience. It enriches your investment performance and your life. The fact that not many of us will do it is why not many of us are money smart or financially free.
“It’s really just common sense— don’t put all your eggs in one basket. The same advice has been suggested by Shakespeare, the Bible, and the Talmud.” — Brendan Mathews
“Make sure all your investments still fit comfortably in your baskets. Do not diversify into hundreds of eggs. That might end in scrambled eggs. 15 to 30 is a good number.” — Andreas G. Schmidt
“The most efficient way to diversify a stock portfolio is with a low-fee index fund.” — Paul Samuelson, 1970 Nobel Prize Economics
Warren Buffett: “… the know-nothing investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Diversification is protection against ignorance.”