(Due to the complicated nature of this topic, the language used in this blog post will be more advanced than in our typical blog post)
Let’s assume for a minute that you were just out of college and took a job working for your eccentric uncle Jim. Although your uncle thinks a little differently than most, he is very smart and owns a successful electronics business. Uncle Jim also has enrolled you in his company’s 401k plan where he matches your dollar for dollar contribution up to $5,000 per year. Recognizing the value of this match, you contribute the full amount to take full advantage of the match and add a combined total of $10,000 to your 401k each year.
However, Uncle Jim shuns the traditional portfolio investing and decides his 401k returns will be based on an annual coin flip. He will flip a coin each December and if heads are the result, he will add 30% to the total portfolio but if you are unlucky enough to get tails, he will take away 10% from the total.
The good news of our little thought experiment is that over enough time, we will get roughly the same number of heads as tails, yielding an average annual return of 10%. However, since you just completed a statistics class your senior year of college, you are aware that there is no guarantee that over the next 20 years you work with your uncle, the results will be equal parts heads and tails. There is a good chance that more heads or more tails come up over the next 20 years and you run the risk that simple bad luck will significantly impact your long-term return. As an example, if fifteen tails come up and only five heads in the next 20 years, you will have achieved effectively no return.
Remembering that statistics class, you approach your uncle with an idea. Would he be willing to split your account into 10 equal parts and flip the coin 10 times each year with the same rules? Your uncle, not seeing much difference in the two strategies, agrees to the change and you are thrilled. Now, instead of betting your nest egg on 20 flips in 20 years, you are getting 200-coin flips in the next 20 years, a much larger number furnishing you very strong odds that the final results will be closer to 100 heads and 100 tails, effectively insuring the desired 10% average annual return. Congratulations, you have just diversified your portfolio.
You created a simple diversification by making investments that have a positive net outcome (coin flips with an average 10% return) and adding more investments that have a low or no correlation to the first investment (i.e. each coin flip is independent and the result of one has no impact on the result of the next). Each year, you will have 10-coin flips and while there is a chance all 10 may come up tails in one year, it is far less probable than if we only had one-coin flip per year. In fact, the more coin flips, the more likely we are to achieve our desired result of 50% heads and 50% tails. We have diversified away from the risk of being unlucky in only a small number of flips.
Think about the actual investment choices in your 401k. Your plan probably offers large-cap stocks, small-cap stocks, international stocks, real estate, long-term bonds, short-term bonds, cash, etc. Each of these asset classes is like a coin flip. They all have an expected positive outcome but can also be subject to bad timing/luck. The expected return of small-cap stocks is about 12% per year on average, but you should be prepared for years of -50% and even several years of negative returns in succession if you are invested for 20 or more years. However, long-term bonds actually have a negative correlation to small-cap stocks. This means that historically when small-cap stocks have fallen, long-term bonds rise in value. It is this negative correlation that smooths out the bumps in the otherwise volatile road of equity investing and allows our average annual returns to be closer to what we expect. Diversification lets us sleep at night when markets are volatile.
Each investment in our portfolio has a positive expected long-term performance (just as our coin flips did); however, each of them also can perform poorly during certain market cycles. When building an efficiently diversified portfolio, the key is to have asset classes that perform differently during different cycles and are thus, negatively correlated. We want certain things to zig while others zag. Anyone who has seen the volatility of the stock market knows that cycles can change on a dime. Today’s bull market can melt into economic collapse in the blink of an eye. That is why it is important not to liquidate those asset classes that are performing poorly in today’s cycle. Today’s pariah could be tomorrow’s hero!
Work with a good financial planner to find the right diversification for your portfolio. Remember, once you set the portfolio in motion, re-balance regularly and don’t sell the asset classes that have performed poorly lately. Selling conservative investments in a booming market means there is nothing to offset the volatile investments when the market falls. Keep a cool head, focus on the long-term, and most importantly, stay diversified no matter what the cocktail party crowd tells you. We may not have an eccentric uncle Jim, but we can diversify as we do.