In the world of investments, a bumpy and unpredictable ride can await those with concentrated and undiversified portfolios and investors who constantly tinker with their asset allocation. Of course, everyone feels in control when recent market performance has been positive, but it’s harder to stay invested during a sharp or prolonged market downturn.
Predicting which part of a market will do best over a given period is tough. The U.S. stock market is the world’s biggest, and it has been a strong performer in recent years. But a decade ago–in 2004 and 2006–it was the second-worst performing developed market in the world.
U.S. small cap stocks were among the top performers in 2016, with a return of more than 21%. A year earlier, their results looked relatively disappointing with a loss of more than 4%. International small cap stocks had their turn in the sun in 2015, topping the performance tables with a return of just below 6%. But the year before that, they were the second worst with a loss of 5%.
Here’s another example. Among developed markets, Denmark was number one in U.S. dollar terms in 2015, with a return of more than 23%. But a big bet on that country the following year would have backfired, as Denmark slid to the bottom of returns by country with a loss of nearly 16%.
For these reasons, the smart thing to do is to diversify, spreading your portfolio across different securities, sectors, and countries. That also means identifying the right mix of investments (e.g., stocks, bonds, real estate) that aligns with your risk tolerance. Using this approach, your returns from year to year may not match the top performing portfolio, but neither are they likely to match the worst. More importantly, this is a course you are likelier to stick with.
If you’ve ever taken a long car trip, you know that conditions along the way can change quickly and unpredictably, which is why you need a vehicle that’s ready for the worst roads as well as the best. While diversification can never completely eliminate the impact of bumps along your particular investment road, it does help reduce the potential outsized impact that any individual investment can have on your journey.
With sufficient diversification, the jarring effects of performance extremes level out. That balance, in turn, helps you stay in invested in your chosen portfolio and on the road to your investment destination.